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Bureau Releases Rate of Return Represcription Staff Report

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Released: May 16, 2013

Federal Communications Commission

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FEDERAL COMMUNICATIONS COMMISSION

445 12TH STREET, SW

WASHINGTON, DC 20554

Prescribing the Authorized Rate of Return

ANALYSIS OF METHODS FOR ESTABLISHING JUST AND REASONABLE RATES

FOR LOCAL EXCHANGE CARRIERS

WIRELINE COMPETITION BUREAU

STAFF REPORT

WC DOCKET NO. 10-90

MAY 16, 2013


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Executive Summary
The rules of the Federal Communications Commission authorize incumbent local exchange
carriers (LECs) subject to rate-of-return regulation to earn a prescribed rate of return, currently
11.25 percent, on specified investment in plant used and useful in the efficient provision of
certain interstate telecommunications services. The authorized rate of return is also used to
determine the support incumbent LECs receive from the Universal Service Fund (USF or Fund)
for High Cost Loop Support and Interstate Common Line Support.
In keeping with its statutory obligation to ensure that rates are just and reasonable, the
Commission must set the rate of return high enough to allow carriers to maintain their credit-
worthiness and attract capital, but no higher. If the rate is too high, customers pay unreasonably
high prices both through direct payments to carriers and through excessive Universal Service
Fund fees.
In the USF/ICC Transformation Order, the Commission concluded that it should represcribe the
authorized rate-of-return and initiated a represcription proceeding. One formula for determining
the rate of return is the Weighted Average Cost of Capital (WACC), which the Commission’s
rules specify is the sum of the cost of debt, the cost of preferred stock, and the cost of equity, each
weighted by its proportion in the capital structure of the telephone companies. Both the National
Exchange Carrier Association and the Ad Hoc Telecommunications Users Committee provided
analyses of the WACC, relying on one or both of the methodologies to find the cost of equity that
the staff uses in this Report. We appreciate their contribution to the record and build on their
work in this Report. Although our analyses differ from theirs in certain respects, the approaches
are fundamentally similar to the approach set out in this Staff Report.
The Commission last represcribed the authorized rate of return in 1990, reducing it from 12 to
11.25 percent. The Commission no longer has current data of the type it used to prescribe the rate
of return in 1990, and substantial changes in technology, regulation, and the marketplace in the
last 23 years raise a number of issues regarding how to represcribe the rate of return.
In an effort to inform the Commission as it moves to resolve this proceeding and set a rate of
return that better reflects market realities and protects the consumers and businesses that pay into
the Fund while providing more certainty for rate-of-return carriers, this Wireline Competition
Bureau Staff Report reviews the record in this proceeding, discusses various methods and data
sources that could be used to determine the WACC, and considers Commission options for
addressing the Commission’s goals and the issues raised by carriers, state regulators, consumer
advocates, and others. Specifically, the Report discusses, among other things:
 Using publicly-traded rate-of-return incumbent LECs as proxies for rate-of-return
incumbent LECs generally to determine the WACC. The Commission’s 1990
represcription proceeding used the Regional Bell Holding Companies as proxies.
 Calculating the cost of equity using both the Capital Asset Pricing Model and the
Discounted Cash Flow Model. In 1990, the Commission used the Discounted Cash Flow
Model to determine the cost of equity.
 Determining a “zone of reasonableness” within which the rate of return can be selected.
Finally, the Report calculates the WACC using various methods and data sources and determines
a zone of reasonable WACC estimates ranging from 7.39 percent to 8.72 percent. Noting, among
other things, the current historically-low interest rates and the infrequency of represcription, the
Report concludes that the Commission should consider establishing the authorized rate of return
in the upper half of this range, between 8.06 percent and 8.72 percent.
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TABLE OF CONTENTS

I. INTRODUCTION ..................................................................................................................................1
II. BACKGROUND ....................................................................................................................................4
III. DISCUSSION.........................................................................................................................................8
A. Identifying and Obtaining Data to Compute the Weighted Average Cost of
Capital ..............................................................................................................................................8
1. Data Needed to Calculate the WACC........................................................................................9
2. Identifying an Appropriate Proxy Group for Rate-of-Return Carriers ....................................11
a. Staff Proposed Proxy.........................................................................................................14
(i) Regional Bell Holding Companies .............................................................................15
(ii) Mid-Size Proxies.........................................................................................................21
(iii) Publicly-Traded RLEC Proxies ..................................................................................23
(iv) Recommendation: the Staff Proposed Proxy ..............................................................25
b. Other Proxies Considered..................................................................................................26
(i) Damodaran Telecom Utility Proxies ..........................................................................27
(ii) NECA Proxies.............................................................................................................29
B. Computing the WACC ...................................................................................................................31
1. Capital Structure ......................................................................................................................36
a. Book Value Capital Structure Results...............................................................................38
b. Comparison of Book Value and Market Value Capital Structure Results ........................42
2. Cost of Debt.............................................................................................................................45
3. Cost of Equity ..........................................................................................................................51
a. Capital Asset Pricing Model (CAPM)...............................................................................62
(i) Primary Variables in CAPM.......................................................................................66
(ii) CAPM Cost of Equity Results ....................................................................................83
(iii) CAPM WACC Range.................................................................................................86
b. Discounted Cash Flow.......................................................................................................93
(i) DCF Variables ............................................................................................................95
(ii) DCF Cost of Equity Results........................................................................................99
(ii) DCF WACC Range ..................................................................................................114
h. Cost of Preferred Stock ...................................................................................................115
4. WACC Results.......................................................................................................................116
5. Establishing the Zone of Reasonableness ..............................................................................117
a. Selecting the Unitary Rate of Return: Times Interest Earned Analysis ..........................119
b. Calculating the TIE Ratio................................................................................................124
(i) Pro Forma TIE Ratios ..............................................................................................125
(ii) Historical TIE Ratios ................................................................................................126
(iii) TIE Ratio Benchmarks..............................................................................................129
(iv) Analysis of Carrier TIE Ratios at Various WACCs .................................................132
C. Grants ...........................................................................................................................................138
IV. CONCLUSION...................................................................................................................................141
Appendix A
List of Further Notice Commenters and Reply Commenters
Appendix B
Comparison of RHC Embedded Cost of Debt Found in 1990 Represcription with
10-Year Treasury Note Yield
Appendix C
Discussion of Book and Market Values in Calculation of Capital Structure
Appendix D1
Historical Book Value Shares of Debt
Appendix D2
Historical Market Value Shares of Debt
Appendix E
Embedded Cost of Debt
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Appendix F
Betas
Appendix G
T-statistics and R-squared Values of Monthly, Weekly, and Daily Betas Used in
CAPM
Appendix H
Cost of Equity: Capital Asset Pricing Model
Appendix I1
Weighted Average Cost of Capital
Appendix I2
Weighted Average Cost of Capital: Alternative Specifications of CAPM Betas
Appendix I3
Weighted Average Cost of Capital: Alternative Sources of Analyst Projections
for DCF
Appendix J
Cost of Equity Using Discounted Cash Flow Model
Appendix K
CAPM and DCF WACC Range
Appendix L1
Pro Forma Pre-Tax Times-Interest –Earned Ratios (Market Value Capital
Structures)
Appendix L2
Pro Forma Pre-Tax Times-Interest –Earned Ratios (Book Value Capital
Structures)
Appendix L3
Pro Forma After-Tax Times-Interest –Earned Ratios (Book Value Capital
Structures)
Appendix M
Historical Times-Interest-Earned Ratios
Appendix N
Long-Term Bond Ratings
Appendix O
Proposed Correction of Rule 47 C.F.R. § 65.302 (Cost of Debt)
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I.

INTRODUCTION

1.
The Federal Communications Commission (Commission) prescribes a unitary
rate of return (commonly referred to as the “rate of return” or “authorized rate of return”) for the
roughly 1200 incumbent local exchange carrier (incumbent LEC) study areas subject to rate-of-
return regulation.1 The authorized rate of return is used to determine interstate common line rates
and special access rates for rate-of-return incumbent LECs2 and is also used in calculating some
forms of support provided by the Universal Service Fund (USF or Fund), including High Cost
Loop Support (HCLS)3 and Interstate Common Line Support (ICLS).4 The Commission, noting
the major changes that have occurred in the market since the authorized rate of return was last
prescribed in 1990, initiated a represcription proceeding in the Further Notice portion of the
USF/ICC Transformation Order.5
2.
The staff of the Wireline Competition Bureau (Bureau) has prepared this Staff
Report (Report) to assist the Commission as it considers prescribing a new authorized rate of
return. Taking into account comments filed in response to the Further Notice released in
conjunction with the USF/ICC Transformation Order,6 as well as regulatory and market changes
since the Commission’s last represcription, this Report analyzes various policies regarding
represcription and possible procedural and substantive changes to the represcription process. We
discuss analytical approaches to calculating the rate of return, with particular emphasis on

1 The Commission is required by Section 201 of the Communications Act of 1934 to ensure that rates are
“just and reasonable.” See 47 U.S.C. § 201(b). Section 205(a) of the Act authorizes the Commission, on
an appropriate record, to prescribe just and reasonable charges of common carriers. See 47 U.S.C. §
205(a).
2 In the USF/ICC Transformation Order, the Commission took rate-of-return incumbent LECs off of rate-
of-return regulation for interstate switched access services. See Connect America Fund et al., WC Docket
No. 10-90 et al., Report and Order and Further Notice of Proposed Rulemaking, 26 FCC Rcd 17663,
17983-84, para. 900 (2011) (USF/ICC Transformation Order), pets. for review pending sub nom. In re:
FCC 11-161
, No. 11-9900 (10th Cir. filed Dec. 8, 2011).
3 See 47 C.F.R. § 36.621(a)(1).
4 See 47 C.F.R. § 54.901.
5 USF/ICC Transformation Order, 26 FCC Rcd at 17870, paras. 639-40. The Commission reduced the
authorized rate of return from 12% to 11.25% in 1990. See Represcribing the Authorized Rate of Return
for Interstate Services of Local Exchange Carriers
, CC Docket No. 89-624, Order, 5 FCC Rcd 7507 (1990)
(1990 Represcription Order). The Commission’s rules require that the Commission issue a notice
inquiring whether it should undertake a represcription if the monthly average yields on ten-year United
States Treasury securities remain, for a consecutive six month period, at least 150 basis points above or
below the average of the monthly average yields in effect for the consecutive six month period immediately
prior to the effective date of the current prescription. See 47 C.F.R. § 65.101. The Commission noted that
the trigger was met and initiated a represcription proceeding in 1998, but the proceeding was terminated in
the MAG Order, leaving the authorized rate of return unmodified. See Multi-Association Group (MAG)
Plan for Regulation of Interstate Services of Non-Price Cap Incumbent Local Exchange Carriers and
Interexchange Carriers
, CC Docket No. 00-256, Second Report and Order and Further Notice of Proposed
Rulemaking, 16 FCC Rcd 19613, 19701, para. 208 (2001) (MAG Order). In the USF/ICC Transformation
Order
, the Commission noted that the monthly average yields for the past six months had been “over 450
basis points below the monthly average yields in the six months immediately prior to the last prescription.”
USF/ICC Transformation Order, 26 FCC Rcd at 17870, para. 640 (citing 10-Year Treasury Constant
Maturity Rate (GS10), Federal Reserve Bank of St. Louis (available at
http://research.stlouisfed.org/fred2/series/GS10) (last visited Oct. 21, 2011)).
6 USF/ICC Transformation Order, 26 FCC Rcd at 18051-56, paras. 1044-60.
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calculating the cost of equity, and examine how best to establish a “zone of reasonableness,” a
range within which the rate of return should be set.
3.
As discussed in greater detail below, we believe a reasonable analytical
approach, using available data, would establish the zone of reasonableness for a unitary rate of
return between 7.39 percent and 8.72 percent.7 Based upon our analysis of another important
financial benchmark for rate-of-return carriers (based upon times interest earned ratios), and
given current historically-low interest rates and the infrequency of represcription, we conclude
that the rate of return should be selected from the upper end of this range, between 8.06 percent
and 8.72 percent.

II.

BACKGROUND

4.
Large market and regulatory changes have occurred since the Commission last
prescribed the unitary rate of return in 1990.8 At that time, there were 135 million incumbent
LEC access lines, with that number increasing at a rate of three percent annually.9 By 2008, the
number of incumbent LEC access lines had decreased to 122 million, and were continuing to
decrease at a rate of 7.5 percent annually.10 In 1990, there were five million wireless subscribers,
while there were 270 million by 2008.11 Since 1990, the Commission has promulgated rules to
implement the 1996 Communications Act12 and expand price cap regulation,13 and has removed
interstate switched access from rate-of-return regulation.14 The provision of video and data
services, including broadband data services by incumbent LECs, has grown exponentially.15 In
addition, there has been substantial industry consolidation.16 The Commission has granted
AT&T, Verizon, and Qwest forbearance from the Cost Accounting Rules, including the filing of
Automated Reporting Management Information System (ARMIS) reports upon which the last

7 Commission rules require that the final determinations of the cost of debt, cost of equity, cost of preferred
stock, and of their capital structure weights be accurate to two decimal places. 47 C.F.R. § 65.306.
8 1990 Represcription Order, 5 FCC Rcd at 7507, para. 1.
9 See Trends in Telephone Service, Federal Communications Commission, Wireline Competition Bureau,
Industry Analysis and Technology Division at Table 7-3 (Sept. 2010) (2010 Trends in Telephone Service),
available at http://www.fcc.gov/reports/trends-telephony-service-2010.
10 Id.
11 Id., Table 11-3 (reporting CTIA statistics).
12 47 U.S.C. § 1302.
13 See, e.g., Joint Petition of Price Cap Holding Companies for Conversion of Average Schedule Affiliates
to Price Cap Regulation and for Limited Waiver Relief
, WC Docket No. 12-63; Consolidated
Communications Companies Tariff F.C.C. No. 2
, Transmittal No. 41; Frontier Telephone Companies Tariff
F.C.C. No. 10
, Transmittal No. 28; Windstream Telephone System Tariff F.C.C. No. 7, Transmittal No. 57,
Order, 27 FCC Rcd 15753 (2012).
14 USF/ICC Transformation Order, 26 FCC Rcd at 18052, para. 1049.
15 Id. at 17983, para. 900.
16 See, e.g., AT&T Inc. and BellSouth Corporation Application for Transfer of Control, WC Docket No. 06-
74, Memorandum Opinion and Order, 22 FCC Rcd 5662 (2007); Order on Reconsideration, 22 FCC Rcd
6285 (2007); SBC Communications Inc. and AT&T Corp. Applications for Approval of Transfer of Control,
WC Docket No. 05-65, Memorandum Opinion and Order, 20 FCC Rcd 18290 (2005); Verizon
Communications Inc. and MCI, Inc. Applications for Approval of Transfer of Control
, WC Docket No. 05-
75, Memorandum Opinion and Order, 20 FCC Rcd 18433 (2005).
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represcription was based.17 The Commission’s represcription rules, however, have remained
largely unchanged for almost two decades.18 Those rules specify that the Commission establish a
unitary rate of return (i.e., a single rate of return) for specified interstate services for all rate-of-
return incumbent LECs,19 and that the Commission may, but need not, initiate a represcription of
this unitary rate of return if there has been a specified change in the yield on U.S. Treasury
securities.20

Estimated Weighted Average Cost of Capital 2002 – 2012

21
0.12
0.1
0.08

C
C
A

0.06

W

Average
FCC
0.04
0.02
0
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

Year


17 See Petition of AT&T Inc. for Forbearance Under 47 U.S.C. § 160 from Enforcement of Certain of the
Commission’s Cost Assignment Rules; Petition of BellSouth Telecommunications, Inc. for Forbearance
Under 47 U.S.C. § 160 from Enforcement of Certain of the Commission’s Cost Assignment Rules
, WC
Docket Nos. 07-21, 05-342, Memorandum Opinion and Order, 23 FCC Rcd 7302, 7307, para. 12 (2008),
pet. for recon. pending, pet. for review pending, NASUCA v. FCC, Case No. 08-1226 (D.C. Cir., filed June
23, 2008); Petition of Qwest Corporation for Forbearance from Enforcement of the Commission’s ARMIS
and 492A Reporting Requirements Pursuant to 47 U.S.C. § 160(c); Petition of Verizon for Forbearance
Under 47 U.S.C. § 160(c) from Enforcement of Certain of the Commission’s Recordkeeping and Reporting
Requirements
, WC Docket Nos. 07-204, 07-273, Memorandum Opinion and Order, 23 FCC Rcd 13647,
13660, para. 23 (2008).
18 47 C.F.R. §§ 65.101 et seq.
19 47 C.F.R. § 65.1.
20 47 C.F.R. § 65.101(a), (b). If the Commission determines that the monthly average yields on ten (10)
year United States Treasury securities remain, for a consecutive six month period, at least 150 basis points
above or below the average of the monthly average yields in effect for the consecutive six month period
immediately prior to the effective date of the current prescription, the Commission is required to issue a
notice inquiring whether a rate of return represcription should commence. 47 C.F.R. § 65.101(a). It is not,
however, required to commence the represcription. 47 C.F.R. § 65.101(b).
21 WACC calculations in this table were made using CAPM with betas from SNL Kagan, which use daily
data and are not adjusted towards one. While our main analysis uses weekly data for the betas and adjusts
them towards one, we show in the report that this methodological difference is inconsequential. We
assume a 5.79 percent market risk premium, and risk-free rates from September 17 of each year.
Otherwise, the methodology is identical to that used for the 2012 capital asset pricing model estimates
described in the report.
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5.
If the Commission elects to represcribe the authorized rate of return, its rules
require the new rate to be based upon its analysis of the cost of debt and equity, and the ratio of
debt to equity, also known as the “capital structure.” Specifically, the Commission is to calculate
a Weighted Average Cost of Capital (WACC) by summing the estimated cost of debt, cost of
preferred stock, and cost of equity, each weighted by its proportion in the capital structure of the
telephone companies taken as a whole.22 Because there is a range of reasonable estimates for
each of the elements of the WACC, the Commission identifies a zone of reasonable WACC
estimates and then decides, based on policy considerations, where within that “zone of
reasonableness” to prescribe the unitary rate of return.23
6.
One thing that has not changed is the critical importance to both the industry and
customers that the Commission establish an appropriate rate of return. The WACC is the
minimum rate of return required to attract capital to an investment (e.g., by incurring debt and/or
selling stock). The rate of return must be high enough to provide investors confidence in the
“financial integrity” of a carrier, so that it can maintain its credit-worthiness and attract capital.24
It “should not be higher than necessary for this purpose,”25 because this would result in
unreasonably high prices for customers and excessive demands on USF. The rate of return
should also be “commensurate with returns on investments in other enterprises having
corresponding risks.”26 As the United States Court of Appeals for the District of Columbia
Circuit (D.C. Circuit) has recognized, “rate of return decisions are appropriately treated as policy
determinations in which the agency is acknowledged to have expertise.”27
7.
Further explaining the need to set the rate of return correctly, the Commission
has observed that if the authorized rate of return exceeds a carrier’s actual WACC, the carrier
may have an increased incentive to expand its rate base inefficiently,28 thereby affecting customer
prices and demands on USF.29 Conversely, if the authorized rate of return is insufficient to cover
carriers’ WACC, carriers will be denied the opportunity to earn a reasonable rate of return on
their investment, and ultimately will decline to make ongoing investments in the provision of
efficient service. In either case, incentives to provide and consume regulated services would be

22 47 C.F.R. § 65.305(a).
23 1990 Represcription Order, 5 FCC Rcd at 7508, para. 7.
24 U.S. v. FCC, 707 F.2d 610, 612 (D.C. Cir. 1983) (quoting Federal Power Comm’n v. Hope Natural Gas
Co.
, 320 U.S. 591, 603 (1944)).
25 U.S. v. FCC, 707 F.2d at 612 (citing Permian Basin Area Rate Cases, 390 U.S. 747, 791-92 (1968)).
26 Illinois Bell Tel. Co. v. FCC, 988 F.2d 1254, 1260 (D.C. Cir. 1993) (quoting Hope Natural Gas Co., 320
U.S. at 603).
27 Id. at 618 (citing Sun Oil Co. v. FPC, 445 F2d 764, 767 (D.C. Cir. 1971)).
28 See, e.g., Policy and Rules Concerning Rates for Dominant Carriers, CC Docket No. 87-313, Further
Notice of Proposed Rulemaking, 3 FCC Rcd 3195, 3219-20, paras. 39-40 (1988); Policy and Rules
Concerning Rates for Dominant Carriers
, CC Docket No. 87-313, Report and Order and Second Further
Notice of Proposed Rulemaking, CC Docket No. 87-313, 4 FCC Rcd 2873, 2889-90, para. 30 (1989).
29 As the Commission noted in the context of USF assessment reform, one of its primary goals was to
“ensure the stability and sufficiency of the universal service fund as the marketplace continues to evolve.”
Federal-State Board on Universal Service et al., CC Docket No. 96-45 et al., Further Notice of Proposed
Rulemaking and Report and Order, 17 FCC Rcd 3752, 3759, para. 15 (2002).
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distorted, creating economic inefficiencies.30 While the fundamental principles of WACC
analysis remain unchanged and largely unchallenged in this proceeding, commenters highlight a
number of changes in regulation, technology, and the marketplace that have occurred since 1990.
These changes raise questions about when and how the Commission should calculate the
estimated cost of debt, preferred stock, and equity, and about how the Commission should
calculate the capital structure of the companies subject to rate-of-return regulation. We discuss
these issues, and other issues raised by commenters, below.

III.

DISCUSSION

A.

Identifying and Obtaining Data to Compute the Weighted Average Cost of
Capital

8.
As discussed above, the WACC is the key to establishing the rate of return. We
therefore begin this section with an analysis of the financial data needed to calculate the WACC
and then consider the sources from which we can obtain that data.
1.

Data Needed to Calculate the WACC

9.
To calculate a company’s (or a group of companies’)31 WACC, we need to
determine: 1) the company’s capital structure, i.e., the proportions of debt, equity, and preferred
stock a company uses to finance its operations; and 2) how much that debt, equity, and preferred
stock cost.32 In these calculations, we will consider book values (also called “accounting values”)
or market values (also called “economic values”), as appropriate, and as discussed in greater
detail below.
10.
While the cost of debt can often be estimated directly for each firm, the cost of
equity for firms that are not publicly traded can only be inferred based on data from firms that are
publicly traded. In the past, the Commission used the Regional Bell Holding Companies (RHCs)
as proxy firms to determine capital structure and the costs of debt, equity, and preferred stock for
all incumbent LECs.33 We discuss below the extent to which the RHCs, as well as other groups

30 A significant portion of the assets to which the authorized rate of return applies will be paid for, directly
or indirectly, from the nationwide universal service funds. This could lower the risks debt and equity
holders bear as compared with purely commercial activities, but that we have made no attempt to quantify
that effect or any other impacts of regulation on carrier risk.
31 The Commission’s rules specify that WACC analysis be based on whole-company costs and capital
structure. See 47 C.F.R. § 65.300. Although carriers are entitled to earn a prescribed rate of return only on
specified investment in plant used and useful in the efficient provision of certain interstate
telecommunications services, i.e., its rate base, 47 C.F.R. § 65.800, it is not possible to buy stock solely in
the LECs’ interstate access operations. 1990 Represcription Order, 5 FCC Rcd at 7516, para. 76.
Accordingly, the Commission must use a company’s overall equity to determine the cost of equity
applicable to the company’s rate base for which the rate of return is authorized.
32 A firm’s cost of debt and equity can vary by line of business depending on the specific risk of the
business. So, too, might a firm’s mix of debt and equity financing vary depending on the risk or other
factors specific to the particular line of business. Thus, the WACC estimate for a particular project or line
of business should be based on the costs of debt and equity for the project or the business line, and on the
mix of financing that would be optimal for that project or business line, even if these are not independently
financed. In practice, we cannot measure the WACC of any particular line of business with sufficient
accuracy (most notably because the relevant data are not available below the level of the firm), and so have
developed WACC estimates that reflect the cost of debt and equity and the mix of debt and equity
financing for the entire business. See 1990 Represcription Order, 5 FCC Rcd at 5710-11, paras. 31-34.
33 See generally 1990 Represcription Order.
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of companies that the Commission could use, are suitable proxies for incumbent LECs generally,
and rate-of-return LECs in particular.
2.

Identifying an Appropriate Proxy Group for Rate-of-Return
Carriers

11.
The reliability of the Commission’s analysis depends in large part on the
representativeness of the proxy group it uses. Accordingly, we must consider how to identify a
group of firms that can serve as an effective proxy for rate-of return LECs as a whole. We
discuss below potential proxy groups identified by our rules, commenters, and Commission staff.
12.
The cost of capital is a function of risk, and it is difficult to measure risk
differences among the incumbent LECs precisely. In selecting a representative proxy group, it is
important to compare the qualitative characteristics of the firms for which the WACC is being
calculated with those of the potential proxies—looking in particular at whether the potential
proxies face similar risks, and whether, in the view of experienced industry observers, the
potential proxies have an institutional setup similar to that of the represented firms.34 It is also
important to consider the type of financial data available about those firms. Staff used the
following three-part test to select proxy companies:
Threshold of Incumbent LEC Operations. Staff attempted to discern the amount of
companies’ total operations that can be classified as incumbent LEC price-regulated
interstate telecommunications services, limiting consideration to those companies for
which this proportion of operations constituted at least 10% of overall operations.
Although this is a low threshold, we note that these are still fundamentally
communications companies, and many of their other lines of business provide related
services.

Similarity to Rate-of-Return Operations. Staff attempted to determine the extent to
which firms offer the same or similar services as those for which we are trying to
determine the WACC. As discussed above, the relevant service is price-regulated
interstate special access and common line service. Companies providing this service will
face similar market and regulatory risks that affect the cost of capital. Companies serving
rural or high-cost areas are more similar to rate-of-return LECs than companies serving
urban areas, and companies subject to rate-of-return regulation are more similar than
those subject to price cap or other incentive regulation.35
Reliability of Financial Data. As discussed in detail below, the analysis of the cost of
equity relies on data associated with the public trading of a company’s equity and the
availability of analysts’ growth estimates of a company. If a company’s equity is traded
infrequently, or is infrequently the subject of analysts’ growth estimates, its financial data
is less reliable in determining the cost of equity. Similarly, a company’s overall financial
health makes its financial data more reliable in determining the cost of equity than that of
a company in financial difficulty.
13.
Though each possible proxy group has its strengths and weaknesses when
analyzed according to these criteria, staff proposes that the Commission use data from a group of

34 See generally Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the
Value of Companies
at 219 (McKinsey & Company, Inc. (2000)).
35 It may also be worthwhile to consider the similarity of operations of publicly-traded “pure play” cable
companies.
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16 carriers (the “Staff Proposed Proxy”) consisting of three groups of proxy carriers discussed
below: the RHCs,36 the Mid-Size Proxy Companies,37 and the Publicly-Traded RLECs.38 We also
discuss our grounds for rejecting proxy groups proposed by commenters in this proceeding.39
a.

Staff Proposed Proxy

14.
We believe it is appropriate to use the RHCs, the Mid-Size Proxies, and the
Publicly-Traded RLECs to create a Staff Proposed Proxy to use as a proxy for the universe of
rate-of-return carriers. While none of these sub-groups, standing alone, is necessarily sufficient,
we believe that the 16 companies that comprise the Staff Proposed Proxy represent a range of
company types and capital costs that collectively can serve as a reasonable proxy for the rate-of-
return carriers. We analyze the WACC for these companies individually, by group, and
collectively. Each of the companies in the Staff Proposed Proxy satisfies the first prong of the
three-part test. That is, based upon staff review of publicly-filed documents, 10 percent or more
of their revenues come from the provision of price-regulated interstate telecommunications
services as an incumbent LEC.
(i)

Regional Bell Holding Companies

15.
The Commission’s current represcription rules explicitly contemplate using the
RHCs40 as proxies,41 but a number of parties filed comments opposing the use of RHCs as proxies
for rate-of-return incumbent LECs.42 For example, the Ad Hoc Telecommunications Users
Committee (Ad Hoc) suggests that the RHCs, among other large companies, are not appropriate
proxies for rate-of-return carriers because larger companies have capital structures “more heavily
weighted toward the relatively more expensive equity than debt” compared to smaller RLECs that
“never go to capital markets to raise funds” and instead “borrow funds directly from [the Rural
Utility Service] at rates that include no risk premium.”43 The National Exchange Carrier

36 The RHCs are AT&T, Verizon, and CenturyLink. The Commission decided in 1990 to use the capital
structure of the Regional Bell Holding Companies rather than the Regional Bell Operating Companies
because the capital structure of the BOCs is subject to manipulation by the holding companies. See 1990
Represcription Order
, 5 FCC Rcd at 5708, para. 8.
37 The Mid-Size Companies are Alaska Communications, Inc., Cincinnati Bell, FairPoint Communications,
Frontier Communications, Hawaiian Tel., Lumos, and Windstream.
38 The Publicly-Traded RLECs are Alteva, Consolidated Communications, HickoryTech, New Ulm
Telephone, Shenandoah Telecommunications, and Telephone and Data Systems.
39 The Staff Proposed Proxy includes all publicly traded Incumbent LECs meeting the test described above,
for which reliable data is available. As discussed below, a number of publicly-traded RLECs were omitted
from the Staff Proposed Proxy.
40 Many commenters in the current represcription proceeding refer to “RBOCs” or “BOCs” or simply
AT&T, CenturyLink, and Verizon. There is no indication that the commenters believe the operating
companies should be used rather than the holding companies, and this Report does not revisit the
distinction between the two.
41 The Commission’s rules specify that the components of the WACC be calculated using RHC data
reported to the Commission through ARMIS. 47 C.F.R. § 65.300(a). The rules do not, however, require
that the Commission use the results of those calculations to determine the unitary rate of return “if the
record in that proceeding shows that their use would be unreasonable.” Id.
42 See, e.g., NECA et al. Comments at 56, n.98 and App. C, Statement of Prof. Randall S. Billingsley,
Billingsley Exhibit RSB-2; see generally Ad Hoc Comments.
43 Ad Hoc Comments at 5-6.
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Association (NECA or NECA et al.) argues that “other companies, when measured on objective
terms, in fact more closely resemble RLECs in terms of business risk than [AT&T and Verizon]
and should accordingly be used in any analysis intended to estimate RLEC costs of capital.”44 In
1990, the Commission addressed the issue of the extent to which the RHCs were representative of
regulated incumbent LEC operations generally, noting RHC diversification, including then-
nascent cellular operations, but concluding that the RHCs were appropriate proxies.45
16.
We agree that RHCs likely differ significantly from other incumbent LECs and
we therefore do not recommend that the Commission rely exclusively on RHC data in a
represcription proceeding.46 Nevertheless, the RHCs, like most other incumbent LECS, whether
subject to price cap or rate-of-return regulation, offer regulated wireline voice service as a
significant portion of their business; this similarity supports the inclusion of RHCs among the
proxies to be used in this proceeding. As discussed above,47 this diversification, in particular with
regard to expansion of wireless service, has continued.
17.
Among the companies in the Staff Proposed Proxy, the financial data available
for the RHCs is more likely to produce a reliable WACC measurement than data from any other
group of incumbent LECs. As compared with the incumbent LECs generally, the RHCs are
subject to substantially greater scrutiny from regulators, analysts and investors, including stock
market traders, and consequently their self-reports are likely to be undertaken with greater care,
and more quickly corrected where errors are made. At the same time, there is relatively accurate
external information available about these firms. For example, their shares are traded frequently,
and in relatively high volumes, by highly informed traders. This means that the share price for
these firms is likely to rapidly capture new information about these companies as it becomes
available. Additionally, the RHCs have many large and sophisticated shareholders, who have
strong incentives to watch the companies’ behavior and to seek damages for misreporting.
Similarly, analysts and credit agencies, all in competition with each other, follow such companies
carefully, and publish reports about the same.
18.
Further, WACC estimates are likely to be most accurate for carriers, such as the
RHCs, with relatively constant and unremarkably high or low debt-to-equity and times-interest-
earned-ratios, and solid bond ratings. Thus, we believe that the nearly certain and significant

44 NECA et al. Comments at 50.
45 1990 Represcription Order, 5 FCC Rcd 7516-19, paras. 76-102. The Commission noted (“[T]he record
does show that the RHCs are also involved in activities which are perceived as riskier than their regulated
telephone business. We therefore find that we should give some weight in our decision to the possibility
that a cost of equity estimate for an RHC as a whole company might somewhat overstate the cost of equity
for interstate access service alone.” Id. at 7517, para. 86.
46 The Commission’s rules specify that the calculations “shall be based on data reported to the Commission
in ARMIS report FCC Report 43-02. 47 C.F.R. § 65.300(a). In 2008, the Commission granted AT&T,
Verizon, and Qwest forbearance from the filing of FCC Report 43-02. See, e.g., Petition of Qwest
Corporation for Forbearance from Enforcement of the Commission’s ARMIS and 492A Reporting
Requirements Pursuant to 47 U.S.C. § 160(c)
, WC Docket No. 07-204, Memorandum Opinion and Order,
23 FCC Rcd 18483 (2008). The Commission has not collected the ARMIS data identified in our rules
since 2007 due to the grant of forbearance to the RHCs. In the Further Notice portion of the USF/ICC
Transformation Order,
the Commission sought comment on what additional data the Commission should
require and rely upon in the absence of current ARMIS data. USF/ICC Transformation Order, 26 FCC
Rcd at 18052-53, para. 1050. Staff recommends that the Commission waive the requirement of Section
65.300 of the Commission’s rules. 47 C.F.R. § 65.300.
47 See supra, para. 4.
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benefit of having a more accurate estimate of the RHCs’ WACCs provides an objective
benchmark for our analysis (albeit one that must be treated carefully). At a minimum, given the
size of the RHCs, the substantially large share of the industry’s debt and equity capital they raise,
and competition among all incumbent LECs for the limited amount of capital provided by debt
and equity investors, WACC estimates for the RHCs provide a benchmark against which to judge
the reasonableness of differences among WACC estimates for all of the incumbent LECs. To
enable comparisons, we report WACC estimates for RHCs separately from WACC estimates for
other incumbent LECs, in addition to developing an overall WACC estimate.
19.
In this vein, the RHCs should be included in any analysis of incumbent LECs’
rates of return because they will provide the most reliable discounted cash flow (DCF) estimates
for the cost of equity. There is a significantly greater number of analysts’ growth estimates for
the RHCs than for the other incumbent LECs. These growth estimates are used to establish the
consensus growth rate used in one of the models (the Discounted Cash Flow, or DCF Model)
used to determine the cost of equity. The greater number of analysts’ growth estimates makes the
consensus growth rate more reliable, and therefore makes the DCF model cost of equity, and
ultimately the WACC, more reliable (though again, such numbers must be treated with care: we
do not assume that that the RHCs are identical to other incumbent LECs, but there are important
similarities between these groups, and it is valuable to have reasonably objective information
about at least one).
20.
For these reasons, we believe that RHCs should be included among those
companies in the proxy group for calculation of the WACC.
(ii)

Mid-Size Proxies

21.
Staff also considered publicly-traded mid-sized incumbent LECs,48 and
recommends that Alaska Communications Services, Inc., Cincinnati Bell, FairPoint, Frontier,
Hawaiian Telcom, and Windstream (the “Mid-Size Proxies”), be included in the Staff Proposed
Proxy for calculation of a composite WACC. The Mid-Size Proxies are more similar to rate-of-
return operations than are the RHCs: unlike Verizon and AT&T, which also provide extensive
wireless service, the Mid-Size Proxies are less diversified and thus more closely match the
majority of incumbent LECs’ wireline service offerings, have a significant fraction of their
incumbent LEC operations in population sparse, high cost, rural areas of the country, and have a
relatively large number of analysts’ growth estimates reflected in the consensus growth rate used
in the DCF model to estimate the cost of equity.
22.
However, these carriers are primarily subject to price cap regulation rather than
rate-of-return regulation, and are much larger than most RLECs, and therefore are still an
imperfect proxy group. In addition, these companies in general have a large share of debt in their
capital structures, low times-interest-earned ratios, and non-investment-grade debt ratings and
thus are less than ideal for estimating the cost of capital for providers with lower, often
subsidized, debt. As with the RHC proxies, we recommend that the Commission include them in

48 See PA PUC Reply at 6. Such a group would be consistent with the Pennsylvania PUC’s
recommendation that “proxy company groups that are composed [of] mid-size carriers that are subsidiaries
of publicly traded holding companies without wireless operations should be utilized for the derivation of
the [return on equity] estimates applicable to the operations of wireline carriers that primarily serve higher
cost rural areas.” We note by way of example that AT&T and Verizon together accounted for over 61% of
wireless subscribers by 2008. Implementation of Section 6002(b) of the Omnibus Budget Reconciliation
Act of 1993
, Fifteenth Report, WT Docket 10-133, 26 FCC Rcd 9664, 9696, para. 31 (2011) (using 2009
statistics).
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calculating a composite WACC, but not rely on them exclusively.
(iii)

Publicly-Traded RLEC Proxies

23.
The RHCs and the Mid-Size Proxies differ from rate-of-return incumbent LECs
in that their operations are not substantially subject to rate-of-return regulation. Staff has
identified seven publicly-traded U.S. incumbent LECs subject to rate-of-return regulation that
could serve as proxies for the Commission’s calculation of the WACC. These carriers are
HickoryTech Corporation, Shenandoah Telecommunications Company, Telephone and Data
Systems, Inc., Consolidated Communications, New Ulm, Lumos, and Alteva49 (the “Publicly-
Traded RLEC Proxies”).
24.
We do not, however, recommend using the Publicly-Traded RLEC Proxies as the
sole proxy because their financial data is not as reliable for the types of calculations needed to
determine the cost of equity. Some of the Publicly-Traded RLEC Proxies have a small number of
analysts’ growth estimates. It is these analyst growth estimates that are used in the DCF model to
determine the cost of equity; if there are too few estimates, the reliability of the DCF estimate of
the cost of equity is reduced. Similarly, some of these small carriers appear to also have thinly
traded stock. Data from stock trades is used by in the Capital Asset Pricing Model (CAPM) to
estimate the cost of equity; stock that is infrequently traded could result in a bias in the CAPM
estimate of the cost of equity. Finally, there are only seven such carriers, a number that is
probably not large enough for measurement errors reflected in the estimates to be expected to
largely offset each other, especially given that these errors might not be totally random and the
fact that any given error may be large.
(iv)

Recommendation: the Staff Proposed Proxy

25.
The staff recommends using all three groups, the Staff Proposed Proxy, to
determine the composite WACC. Each of the companies in the Staff Proposed Proxy provides
price-regulated interstate service as an incumbent LEC, and such service is estimated to exceed
the ten percent threshold of the first prong in the Commission’s test: Threshold of Incumbent
LEC Operations. With regard to the second and third prongs, however, there appears to be an
inverse relationship between the similarity to rate-of-return operations and the reliability of
financial data. The RHC Proxy companies have frequently-traded equity and numerous analysts’
growth estimates, making their financial data highly reliable for purposes of our CAPM and DCF
analysis, but with their more urban service areas and price-cap or price-flexibility regulation,
have operations least similar to those of rate-of-return carriers. Accordingly, we do not
recommend relying exclusively on the RHCs despite the reliability of their financial data.
Conversely, the Publicly-Traded RLEC Proxies, subject to rate-of-return regulation and serving
rural and higher cost areas, are most similar to rate-of-return operations. However, their stock
tends to be infrequently traded, and there are few analysts’ growth estimates for use in our CAPM
and DCF estimates. The Mid-Size Proxies, although subject to price cap regulation, have more
rural and high-cost service areas than the RHC Proxies, and in that regard have greater similarity
to rate-of-return operations. The Mid-Size Proxies’ stock is more frequently traded than that of
the Publicly-Traded RLEC Proxies, and there are more analysts’ growth estimates for the Mid-
Size Proxies than there are for the Publicly-Traded RLEC Proxies. However, the
disproportionate capital structure (specifically with regard to the large share of debt) and non-
investment-grade debt rating of many of these companies make their financial data less reliable
than that of the RHC Proxies. Collectively, the three groups represent a wide spectrum of
incumbent LEC operations, include both price cap and rate-of-return regulated operations, and

49 Alteva was formerly Warwick Valley Telephone.
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include those incumbent LECs with the most widely traded equity, allowing greater confidence in
the calculations that rely on the public trading of stock, especially given that it is highly uncertain
where within that spectrum non-publicly-traded RLECs lie.
b.

Other Proxies Considered

26.
Ad Hoc and NECA each submitted a proposal for data sources for calculating the
WACC.50 While we build on the Ad Hoc and NECA analyses in several other respects, for the
reasons discussed below, we believe the Staff Proposed Proxy better reflects the risks faced by
rate-of-return carriers, and would therefore enable the Commission to better estimate the rate of
return those carriers require.
(i)

Damodaran Telecom Utility Proxies

27.
Ad Hoc proposes to use publicly available cost of capital data compiled by
Professor Aswath Damodaran of the Stern School of Business at New York University,
specifically the “telecom utility” sector of Prof. Damodaran’s Cost of Capital by Sector
compilation (the “Damodaran Telecom Utility Proxies”).51
28.
Although the Damodaran Telecom Utility Proxies data is readily available to the
public and has the advantage of having been compiled by a source without an interest in this
proceeding,52 we believe the Staff Proposed Proxy is preferable for determining the rate of return
for U.S. rate of return incumbent LECs. Although the Damodaran Telecom Utility Proxies
include several publicly-traded incumbent LECs included in the Staff Preferred Proxy (i.e.,
Alaska Communications Services, Inc., CenturyLink Inc., Cincinnati Bell, Consolidated
Communications, FairPoint Communications, Frontier Communications, HickoryTech Corp.,
New Ulm Telecom Inc., Alteva, and Windstream Corp.), the majority of the Damodaran Telecom
Utility Proxies are either (primarily) foreign (e.g., B Communications Ltd (Israel), BCE Inc.
(Canada), BT Group ADR (United Kingdom), Deutsche Telekom ADR (Germany), Hellenic
Telecom Org. SA (OTE) (Greece), Manitoba Telecom Services Inc. (Canada), Telefonica SA
ADR (Spain), Telefonos de Mexico ADR (Mexico), and therefore not necessarily subject to the
same market conditions or regulatory structure as U.S. rate-of-return incumbent LECs, or do not
provide service as incumbent LECs (ERF Wireless Inc., IDT Corp., ITC Deltacom, Level 3
Communications, Spot Mobile International Ltd., tw telecom, XO Holdings Inc.) The
Damodaran Telecom Utility Proxies may be more representative of the global
telecommunications industry generally than is the Staff Preferred Proxy, but for the narrow
purpose of determining the WACC for U.S. rate-of-return incumbent LECs, we believe the Staff
Preferred Proxy is better suited than the Damodaran Telecom Utility Proxies.

50 Ad Hoc Comments at 4-6; NECA et al. Comments at 56-57 and App. B at 8-11.
51 Aswath Damodaran, Cost of Capital by Sector, DAMODARAN ONLINE,
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.htm (last visited Oct. 2, 2012). For
2011 the Damodaran Telecom Utility Proxies were: Alaska Communications, Inc., B Communications Ltd,
BCE Inc., BT Group ADR, CenturyLink Inc., Cincinnati Bell, Consolidated Communications, Deutsche
Telekom ADR, ERF Wireless Inc., FairPoint Communications, Frontier Communications, Hellenic
Telecom Org. SA (OTE), HickoryTech Corp., IDT Corp., ITC Deltacom, Level 3 Communications,
Manitoba Telecom Services Inc., New Ulm Telecom Inc., Otelco Inc., Spot Mobile International Ltd.,
SureWest Communications, Telefonica SA ADR, Telefonos de Mexico ADR, tw telecom, Warwick Valley
Tel Company (now Alteva), Windstream Corp., and XO Holdings Inc. Id.
52 Ad Hoc Comments at 5.
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(ii)

NECA Proxies

29.
NECA proposes to use financial data from a group of twenty firms (the “NECA
Proxies”) that it describes as facing “comparable overall risk” to the universe of rate-of-return
incumbent LECs. The NECA Proxies are: 3M Company, Abbott Labs, Advance Auto Pt.,
Albemarle Corporation, Autoliv, Inc., Bard C R, Inc., Baxter International, Church & Dwight,
Coca Cola Company, Cooper Industries, Plc., Dentsply International, Ecolab, Inc., Flowers
Foods, Flowserve Corporation, General Dynamics, Idex Corporation, Johnson & Johnson,
Raytheon Company, Sigma Aldrich, and V F Corporation. NECA selected its proxies by
calculating a vector of variables chosen to measure financial risk for an “average RLEC.”53
NECA then conducted a cluster analysis of firms that had the appropriate data available in both
the Zacks Investment Research data application Research Wizard and in the Value Line
Investment Survey, selecting the cluster that was closest to the value of the “average RLEC.”
While this approach is not necessarily invalid, it should be used in conjunction with common
sense analysis of business conditions.
30.
The representativeness of proxy firms is particularly at issue when, as with the
NECA Proxies, the proxy companies are facially quite dissimilar to the rate-of-return incumbent
LECs. Unlike the Damodaran Telecom Utility Proxies, the NECA Proxies are not limited to the
telecommunications field. Indeed, the portfolio does not include a single telecommunications
company, and is instead based on companies – like Coca Cola, Johnson & Johnson, or Raytheon
– that have little business resemblance to rate-of-return carriers. Like the Damodaran Telecom
Utility Proxies, the NECA Proxies include foreign companies. As discussed above, we find this
makes them less suitable proxies because foreign, non-incumbent LEC companies do not face the
same market risks or regulatory structure that rate-of-return incumbent LECs face. Finally, even
if we were to overcome these hurdles, NECA has not sufficiently demonstrated that the financial
risk values it uses as an RLEC average are in fact representative. For all of these reasons, we do
not recommend using the NECA Proxies in the calculation of the WACC.

B.

Computing the WACC

31.
As discussed above, the WACC estimates the rate of return that the incumbent
LECs must earn on their investment in facilities used to provide regulated interstate services in
order to attract sufficient capital investment. The Commission’s rules specify that the composite
WACC is the sum of the cost of debt, the cost of preferred stock, and the cost of equity, each
weighted by its proportion in the capital structure of the telephone companies:54

WACC = (Equity/(Debt + Equity + Preferred)) x Cost of Equity + (Debt/(Debt + Equity +

Preferred)) x Cost of Debt + (Preferred/(Debt + Equity + Preferred)) x Cost of Preferred

32.
In this part, we calculate these elements and determine the WACC for the
recommended Staff Proposed Proxy. First, based upon the financial data of the companies in the
Staff Proposed Proxy (the Proxy Firms), we determine the capital structure of the Proxy Firms,
i.e., the proportions of debt, equity, and preferred stock the Proxy Firms use to finance their
operations. We then calculate how much that debt, equity, and preferred stock cost the Proxy
Firms. Finally, we multiply the proportion of debt, equity, and preferred stock by their respective

53 NECA et al. Comments at App. C, Statement of Prof. Randall S. Billingsley, Attach. 3. This vector
contains normalized values of the following variables: equity-to-total capital ratio; cash flow-based interest
coverage ratio; the standard deviation of the ratio of a firm’s operating cash flows to total assets; and the
firm’s operating cash-flow-to-total assets.
54 See 47 C.F.R. § 65.305(a).
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costs; the sum of these products is the WACC.
33.
The formulas for determining the cost of debt, cost of preferred stock, and capital
structure are codified respectively in sections 65.302, 65.303, and 65.304 of the Commission’s
rules.55 The rules do not, however, specify a formula for the cost of equity.56
34.
In the Further Notice portion of the USF/ICC Transformation Order, the
Commission sought comment on whether it should augment or replace its WACC calculation
with other analyses or approaches.57 Noting that “many rate-of-return companies have diversified
beyond regulated voice services, for example to offer broadband, video, or wireless services,”58
the Commission sought comment on whether the WACC “should be computed for only the
regulated portion of the company’s business, or at the level of the entire company?”59 Although
there was little dispute regarding the WACC formula itself, there were differing views on how to
measure the components of the WACC.60
35.
Having recommended the type of data the Commission should use, and the
companies that would comprise the Staff Proposed Proxy, in this section, we now analyze the
data to determine: (a) capital structure; (b) the cost of debt; (c) and the cost of equity. As
discussed below, we do not have sufficient data to calculate the percentage of preferred stock in
the capital structures or to calculate the cost of preferred stock. Accordingly, as discussed below,
we have not included it in these calculations.
1.

Capital Structure

36.
The capital structure of a firm is the percentage of debt, preferred stock, and
equity the firm uses to finance its operations. For example, if a firm had $60 of debt, $10 of
preferred stock, and $130 of equity, then its capital structure would be 30 percent debt
(60/(60+10+130)), five percent preferred stock (10/(60+10+130)); and 65 percent equity
(130/(60+10+130)).
37.
The WACC can be calculated with the “observed” capital structure, which is
based on book values or the market values at a moment in time, or a firm’s “target” capital
structure, which is the capital structure the firm wishes to obtain.61 The Commission’s rules

55 47 C.F.R. §§ 65.302-65.304.
56 47 C.F.R. § 65.301.
57 USF/ICC Transformation Order at 18052, para. 1049.
58 Id.
59 Id.
60 See, e.g., NECA et al. Comments at App. C, Statement of Prof. Randall S. Billingsley.
61 To maximize its value, a firm will seek to minimize its cost of capital by targeting its optimal mix of debt
and equity. This is not, however, a reference to a hypothetical capital structure, such as one that regulators
sometimes use to develop WACC estimates. For example, an all-equity firm could lower its WACC by
adding relatively low-risk, tax-deductible, low-cost debt to its capital structure. But it could only lower the
WACC up to a point, after which the benefits of the additional debt would be more than offset by higher
debt and equity costs, as the additional debt significantly increases the probability of financial distress,
including default and bankruptcy, substantially increases agency costs and intangible costs, such as those of
losing the flexibility of financing future project with debt. See Roger A. Morin, Regulatory Finance:
Utilities’ Cost of Capital
, 413-429 (Public Utilities Reports 1994) (Morin Regulatory Finance). A firm’s
target capital structure can be difficult for firm outsiders to assess; there is “no universal theory of the debt-
equity choice,” Stewart C. Myers, Capital Structure, J. Econ. Persp. 81-102 (Spring 2001) (Myers Capital
Structure
).
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specify that capital structure is to be calculated based upon book values.62 A discussion of the
issues associated with target capital structure and with using book values and market values in
calculating the capital structure is included in Appendix C. For the reasons given below, we
recommend that the Commission use market values rather than book values when calculating
capital structure, as we find market values to be a better indication of the firms target capital
structures.
a.

Book Value Capital Structure Results

38.
The Commission’s rules currently require that the capital structure be calculated
using the observed book values of debt, preferred stock, and equity. “Book value” means the
value on the company’s balance sheet. Under the Commission’s rules, capital structure is
calculated as follows:63

Book Value of a Particular Component / (Book Value of Debt +Book Value of Preferred

Stock + Book Value of Equity)

39.
Appendix D1 shows the share of debt based on book values, in the capital
structure for each carrier in the Staff Proposed Proxy from 2008 to 2012. The average share of
debt for the Staff Proposed Proxy was 73 percent in 2012, based on book values. However, we
question whether this average share of debt is representative. For instance, six of the 16 carriers
in the sample have remarkably high debt shares both absolutely and relative to their debt shares
based on market values. 64

Company

Book Value Share

of Debt (as a
percentage of total
company book
value)
ACS
107%
CBT
135%
Consolidated
90%
FairPoint
150%
Lumos
82%
Windstream
88%
40.
By comparison, AT&T’s debt percentage is 42 percent when based on book
values, and Verizon’s debt percentage is 36 percent.
41.
Additionally, ACS’s, CBT’s, and FairPoint’s book value capital structures are
not representative of their target capital structures,65 i.e., the capital structures that the companies

62 47 C.F.R. § 65.304.
63 47 C.F.R. § 65.304.
64 Sometimes accounting losses, arising, for example, from large amounts of interest payments,
depreciation, or amortization, result in debt levels that exceed the book value of the firm’s assets. In these
cases, a firm might have a book capital structure that has more than 100% debt and a negative equity
percentage equaling the absolute value of the amount by which the debt percentage exceeds 100%.
65 Excluding the six carriers that have remarkably high debt shares, i.e., debt shares 82 percent or greater, in
2012, the average book value capital structure is 51 percent debt, and the average market value capital
structure is 44 percent debt.
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would strive to obtain over time. A book value of debt that exceeds 100 percent of debt plus
equity is nonsensical. It is also at least unlikely that even a 100% debt capital structure is
optimal.66 As noted, a firm’s capital structure is optimized by choosing the levels of debt and
equity which minimize its over-all cost of capital necessary for its operations.67 It is a widely
held belief that there are tradeoffs between the benefits of debt financing versus those of equity
financing,68 which means that optimal capital structure will involve a mix of debt and equity.
ACS, CBT, and FairPoint have non-investment-grade bond ratings. Consolidated, Windstream,
and Lumos have book values unlikely to represent their target capital structures, as the high
degree of leverage of Consolidated and Windstream is likely a reason that they also have lower
debt ratings. (Lumos has no debt rating.) This suggests that even a 100% debt capital structure
would not minimize these companies’ WACC, as the penalty for a lower debt rating is high
interest rates.
b.

Comparison of Book Value and Market Value Capital
Structure Results

42.
Because several carriers have book value capital structures in excess of 100
percent debt, we are concerned that the book value calculations required by Section 65.304 of the
Commission’s rules69 may not provide reasonable data as required by Section 65.300.70 As
discussed above, market value calculations reported on Appendix D2 are an alternative to book
value calculations; here we compare the two calculations. Overall, as explained in more detail
below, we believe that capital structures based on market values almost certainly provide a more
accurate approximation of the carriers’ target capital structures.71 We note that NECA and Ad
Hoc arrive at results that are closer to our chosen market capital structure of 54 percent (see both
Appendix D2 and Appendix I1) than to our book capital structure of 73 percent. In particular, Ad

66 Indeed, if a firm’s stock trades at a positive price, there is a strong presumption that the firm has a
positive equity value and therefore its debt is less than 100% of debt plus equity.
67 See, e.g., Giacchino and Lesser, Principles of Utility Corporate Finance at 80-82 (Public Utilities
Reports 2011) (Giacchino and Lesser) noting the optimal debt/equity ratio for a regulated firm may be
different from the debt/equity ratio for a non-regulated firm.
68 While the exact nature of this tradeoff is an open question, theories addressing it include the “tradeoff,”
“pecking order,” and “cash flow” theories. Myers Capital Structure at 81-102. They depart from the classic
framework laid out by Modigliani and Miller, Franco Modigliani and Merton H. Miller, The Cost of
Capital, Corporation Finance and the Theory of Investment, 48 A. Econ. Rev. 261-297 (June 1958), in
which capital structure has no effect on the value of a firm.
69 47 C.F.R. § 65.304.
70 47 C.F.R. § 65.300. The target capital structure of a firm is difficult, if not impossible, to ascertain
precisely. However, if a given firm has a poor bond rating and a capital structure that differs significantly
from the capital structures of firms with solid bond ratings in the same industry—whether these differences
show up in comparisons of book value or market value capital structures—we reasonably can conclude that
the given firm’s observed capital structure could not be its target capital structure. Where the capital
structure of a firm is so exaggerated and so obviously out of line with such an industry benchmark, as with
some of the firms in our sample, its use might render an estimate of the WACC for that firm meaningless,
and a prescription based upon that estimate unreasonable.
71 “Your first choice should be to use the firm’s target capital structure for the weights. However, if you are
an outside analyst and do not know the target weights, it would probably be best to estimate weights based
on the current market values of the capital components.” Eugene F. Brigham, Phillip R. Daves,
Intermediate Financial Management, 392 SW. C. (Feb. 23, 2012).
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Hoc arrives at a share of debt of 46 percent,72 and NECA uses a share of debt of 21 percent.73

Company

Book Value of

Market Value of

Debt (as a

Debt (as a

percentage of total percentage of total
company book
company book
value)
value)
ACS
107%
86%
CBT
135%
71%
Consolidated
90%
66%
FairPoint
150%
82%
Lumos
82%
59%
Windstream
88%
62%
43.
By comparison, AT&T’s debt percentage based on book value is 42 percent, as
compared to 26 percent based on market value; and Verizon’s debt percentage is 36 percent based
on book values, as compared to 28 percent based on market values. The share of debt that these
two carriers have in their capital structures is much lower than the share of debt in the capital
structures of the six carriers mentioned above, and both AT&T”s and Verizon’s book value and
market value debt shares are relatively close, in contrast to the book value and market value debt
shares of the six carriers. In addition, AT&T and Verizon have highly, but not the highest, rated
investment grade debt,74 which would suggest that the capital structure that we observe for these
carriers likely better reflects their target capital structure than the same measure for the other six
carriers.75

72 Ad Hoc Comments at 18.
73 NECA et al. Comments, App. C, Statement of Prof. Randall S. Billingsley at 8.
74 Investment grade bonds have a relatively low risk of default and therefore a relatively low yield. These
bonds are rated “Baa3” or higher by Moody’s and “BBB-” or higher by Standard & Poor’s and Fitch. Non-
investment grade bonds have a relatively high risk of default. These bonds are rated “Ba1” or lower by
Moody’s and “BB+” or lower by Standard & Poor’s and Fitch. See
http://www.fitchratings.com/web_content/ratings/fitch_ratings_definitions_and_scales.pdf ,
http://img.en25.com/Web/StandardandPoors/Ratings_Definitions.pdf; http://www.moodys.com/ratings-
process/Ratings-Definitions/002002 (last visited Apr. 16, 2013).
75 Calculating these carriers’ average capital structures over the five-year period from 2008 to 2012 might
make their target capital structure more evident. A large amount of debt financing or equity financing in a
single year, or sharply negative earnings or a random economic occurrence during the last two or three
years might produce a significant deviation from the target capital structure. Five years is likely to be long
enough that the historical effects of any such individual developments would be lessened by the averaging;
at the same time, the period likely is short and recent enough to be representative of the carriers’ current
financial situation. The exception to the usefulness of looking at the average would be FairPoint, which
entered and exited bankruptcy during the five-year period. Accordingly, we do not give any weight to what
the average for FairPoint might tell us. Based on book values, the average of the five-year average share of
debt for the sample of carriers, excluding FairPoint, and also Hawaiian Telcom and Lumos, as capital
structure data are not available for either of the latter two carriers for every year of the five-year period, is
63%, which is significantly greater than 46%, the average of the five-year average share for these carriers.
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44.
We notice similar trends across the different proxy groups. In book value
calculations for 2012, the RHCs had an average of 43 percent debt, the Mid-Size Carriers had an
average of 103 percent debt; and the Publicly-Traded RLECs averaged 60 percent. By contrast,
in market value calculations the RHCs averaged 33 percent debt, the Mid-Size Carriers averaged
72 percent debt, and the Rate-of-Return Carriers averaged 47 percent debt.76 We therefore
recommend that, despite precedent to the contrary (when the proxy group was the RHCs),77
market value capital structures should be used to calculate the WACC.78
2.

Cost of Debt

45.
The Commission’s rules provide that the cost of debt79 is calculated as follows:

Excluding the six carriers that have remarkably high debt shares, the average of the five-year average book
value capital structures is 44%, which is relatively close to 35%, the average of the five-year average
market value capital structures.
Based on five-year average book values, the four carriers (listed in the table above, excluding FairPoint and
Lumos) have remarkably high debt shares both absolutely and relative to their debt shares based on market
values. Based on average book values, ACS’s debt is 102% of its capital structure, as compared to 67%,
based on market values; CBT’s is 144%, as compared to 78%; Consolidated’s is 92%, as compared to 66%;
and Windstream’s is 91%, as compared to 57%. Again, based on the averages, these carrier’s book value
capital structures are not likely to be representative of their target capital structures, as these structures
exceed 91% or greater.
76 See http://www.sec.gov/edgar.shtml (last visited Apr. 16, 2013) for individual firms’ 10-K reports.
77 See 1990 Represcription Order, 5 FCC Rcd at 7510, para. 28.
78 Having concluded that we should use market values to determine the capital structure, the question
remains whether to use data for the most recent year, 2012, or whether to use market values averaged over
a longer period of time, such as the five-year period discussed above. Based on market values, the average
share of debt in 2012 for the 13 carriers, excluding FairPoint, Hawaiian Telcom, and Lumos, is 51%, while
the average of the five-year average share for these carriers is 46%. We conclude that the analysis would
not be significantly affected by the choice between these two values. We will use 2012 market values,
however, because these values reflect investors’ expectations, and the same expectations are reflected in
our cost of equity estimates. In theory, if we were to use the five-year average market values, we would
have to adjust the cost of equity downward slightly to reflect the slightly lower risk associated with the use
of these market values in capital structures as opposed to the risk associated with the use of the 2012
market values. We note that there are financial formulas that can be used to make such an adjustment
where one is warranted. Roger A. Morin, New Regulatory Finance (Public Utilities Reports 2006) at 220-
23, 243, and 479-482 (Morin New Regulatory Finance).
While the capital structure adjustment to reflect relatively less debt and more equity by itself would
increase the WACC, the downward adjustment to the cost of equity would reduce the WACC, partially
offsetting the effect of the capital structure adjustment. The adjustment to the capital structure is relatively
easy to make, but the adjustment to the cost of equity is relatively complex. As the two adjustments are
offsetting, the net effect of choosing 2012, rather than five-year average, market value capital structures
could be small.
79 After-tax cost of debt is typically used in industry calculations of the WACC. In these cases, the WACC
is used as the discount rate in calculating the net present value of future cash flows. The stream of future
cash flows to be discounted assumes that the firm will finance these flows with equity; the recognition of
debt financing is through the use of the after-tax cost of debt when developing the WACC. However, the
rate-of-return carriers regulated by the FCC develop a revenue requirement used to set prices in part by: 1)
calculating the total allowable return on rate base; (2) calculating the taxable fraction of the total return that
is available to shareholders after paying the tax-deductible interest on the debt; and applying the federal and
state corporate income tax rates to the equity holders’ fraction of the total return to calculate the carrier’s
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Embedded Cost of Debt=Total Annual Interest Expense/Average Outstanding Debt

80
where “Total Annual Interest Expense” = “the total interest expense for the most recent two years
for all local exchange carriers with annual revenues equal to or above the indexed revenue
threshold as defined in § 32.9000” and “Average Outstanding Debt” = the average of the total
debt for the most recent two years for all local exchange carriers with annual revenues equal to or
above the indexed revenue threshold as defined in § 32.9000.81 These data are readily available
from Staff Proposed Proxy carriers’ Form 10-Ks.
46.
As a threshold matter, we believe that this equation is incorrect: it uses two
years’ interest expense divided by an average of two years’ total debt, resulting in an
overstatement of the cost of debt. This would approximately double the true embedded cost of
debt. We therefore recommend that the Commission instead use the following equation for
calculating debt based on the most recent year’s interest expense:

Embedded Cost of Debt=Previous Year’s Interest Expense/Average of Debt Outstanding at the


income taxes. The total return and income taxes are part of the carrier’s revenue requirement. Under this
approach, the pre-tax cost of debt is used to calculate the WACC and that calculation enables the carrier
fully to compensate its debt and equity holders and to pay the taxes on the return available to equity
holders. Accordingly, the WACC estimates we develop in this Report reflect the pre-tax cost of debt.
When the WACC is used outside of the context of calculating a revenue requirement in this manner the
pre-tax cost of debt might have to be adjusted downward to account for the tax benefits of debt financing,
the so-called “tax shield.”
80 47 C.F.R. § 65.302. The Commission’s rules require that embedded cost of debt be used to calculate the
WACC, which is logically consistent with its rules requiring the use of an original cost (essentially a book
value) rate base. There is an argument for use of current debt yields in place of the embedded cost of debt,
as current yields better reflect the opportunity cost of debt capital invested in the firm. However, current
debt yields multiplied by the debt holders’ share of a book value rate base does not provide these investors
with their opportunity cost. If the rate base instead were based on market value, current debt yields should
be used in place of the embedded cost of debt, to better reflect opportunity cost. See Morin New
Regulatory Finance
at 26-27.
To illustrate why the use of current debt yields in calculating the WACC would not provide debt holders
with their opportunity cost, assume that the embedded cost of debt is 5%, the current yield on equivalent
debt is 2.5%, the cost of equity is 10%, and that the rate base is $100 and is financed with $50 of debt and
$50 in equity, each expressed in book value terms. The debt holder receives the embedded cost of debt,
5%, times the debt share of the book value rate base, $50, or a return of $2.50, which matches the
contractual obligation of the firm to its debt holders. The debt holder receives a return of $2.50, or five
percent, on the book value share of the rate base, $50, regardless of the current yield on equivalent debt,
2.5% in our example. Moreover, the WACC would be 6.25% if it were based on the current debt yield
rather than the embedded cost of debt (2.5% current cost of debt times the debt holders’ share of the rate
base, 50%, plus the cost of equity, 10%, times the equity holders’ share of the rate base, 50%). The 6.25%
total rate of return applied to the rate base of $100 yields a total return of $6.25. Given that the fixed
obligation on the debt is $2.50, the return that remains to compensate equity holders after payment to the
debt holders is $3.75, which equates to a rate of return of only 7.5% on the book value of the equity
holders’ invested capital of $50 ($3.75 divided by $50), much less than the rate of return equity holders
require, 10% in our example.
If instead the embedded cost of debt is less than the current yield on equivalent debt, and the WACC is
based on that current yield, debt holders again receive a return equal to the fixed amount of the contractual
obligation on the outstanding debt, while equity holders this time receive a return that is greater than they
require.
81 47 C.F.R. § 65.302.
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Beginning and at the End of the Previous Year

47.
Alternatively, an estimate of the current cost of debt for a given company could
be based on the current yield on bonds that have the same rating as and a maturity that is similar
to the company’s bonds. Such an estimate is likely to be imprecise in at least some cases, as it
would be difficult using such a simple approach to account for the characteristics of debt that
significantly affect the yields they pay. Such debt characteristics include the maturity, e.g., 5, 10,
or 20 years, fixed versus variable interest rates, seniority, and whether the debt is callable or
convertible. A more precise calculation might also require knowledge of how much of each type
of debt instrument each company uses. However, as interest rates have been declining for a
number of years, and companies that are in good financial health typically are able to refinance,
on average the embedded cost of debt and the current cost of debt for these companies should not
differ significantly, provided there have not been substantial changes in the cost of debt since the
last filing of the companies’ 10-Ks. Thus, we recommend using the method specified in the
Commission’s rules, as corrected, to estimate the cost of debt, at least at this time. We note,
however, that for companies not in good financial health, the embedded cost of debt may to some
extent reflect low rates to which the companies no longer have access. Whether the WACC is to
be based on the Commission’s cost of debt formula or a current cost of debt calculation, the
Commission should consider calculating the WACC based upon firms that have either
investment-grade bond ratings, or times-interest-earned ratios roughly equal to the ratios of firms
that have such a rating, given that the WACC estimates of such firms, firms that are not in
financial distress, generally would be more reliable.
48.
The embedded cost of debt calculated as described above, based upon data from
the Staff Proxy Firms’ SEC filings, is reported in Appendix E. The average embedded cost of
debt for all 16 carriers is 6.19 percent. For the RHCs it is 5.17 percent, the lower rate likely
reflecting, among other things, their financial stability in the eyes of lenders. The Mid-Size
Proxies pay an average interest rate of 7.65 percent. The Publicly-Traded RLEC Proxies pay an
average interest rate of 5.14 percent on their debt.
49.
We note that it may be necessary to reduce, or cap, the embedded cost of debt
due to the availability of government subsidized loans to most, if not all, rate-of-return carriers.
When the interest rates carriers face are not market-based but rather subsidized by the
government or by non-profit entities (e.g., the Rural Utilities Service (RUS), CoBank, or the
Rural Telephone Finance Cooperative (RTFC)), these subsidized rates must be taken into account
in calculating carriers’ cost of debt. This is because RLECs may have access to loans at below-
market interest rates; for example, RUS currently offers loans with interest varying from current
Treasury rates to no more than five percent.82 If such extensive funding is readily available to
most RLECs from these sources, then even a generous estimate of the cost of debt should be no
more than the current highest rate charged by RUS, CoBank, or RTFC. It is unclear, however,
whether it would be feasible and/or unduly burdensome for a carrier to finance all of its assets
with loans from these lenders, and to refinance older debt at current rates.
50.
We point out that the staff estimate of the cost of debt, 6.19 percent, is higher
than the estimates provided by NECA (4.42 percent) and Ad Hoc (3.63 percent). Of course, the
NECA and Ad Hoc estimates were for very different groups of proxy firms. NECA uses the
expected yield on corporate bonds rated A- by Standard and Poor’s.83 This is the average bond

82 See http://www.rurdev.usda.gov/supportdocuments/telecomloansflyerfactsheet.pdf (last visited Apr. 16,
2013).
83 NECA et al. Comments, App. C, Statement of Prof. Randall S. Billingsley at 8.
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rating of the firms in their portfolio. Ad Hoc relies on the information made publicly available by
Prof. Damodaran to obtain its cost of debt estimates. Damodaran uses sector-by-sector debt
estimates,84 and Ad Hoc uses his reported after-tax cost of debt to calculate the WACC. As
explained in this Report, the pertinent cost of debt in the context of how the FCC calculates
revenue requirements is the pre-tax cost of debt. Using the pre-tax cost of debt provided by Ad
Hoc,85 the Ad Hoc cost of debt is 4.79 percent.86
3.

Cost of Equity

51.
Equity is the value of a firm’s assets, such as equipment, patents, and goodwill,
after the firm’s financial liabilities have been deducted. The Commission’s rules do not specify
how the cost of equity is to be calculated,87 and there are several asset pricing methods that might
be used to estimate the cost of equity. For its preliminary analysis in the USF/ICC
Transformation Order
, the Commission used CAPM, the most widely used method in
commerce.88 The Commission sought comment on using CAPM and on using the Discounted
Cash Flow Model (DCF), on which it relied to calculate the cost of capital in the 1990
Represcription Order
.89 Both models calculate the cost of equity based upon an analysis of
firms’ common stock. Parties offered little discussion regarding CAPM or the difference between
CAPM and DCF. NECA provided analysis based upon both DCF and CAPM,90 and Ad Hoc’s
comments are based on a study using CAPM.91 We discuss below both of these popular models
for measuring the cost of equity. In this Report we use both models to determine the cost of
equity, and to create a zone of reasonableness, because both models have different limitations.92
52.
Background. Equity derives its market value from the expected present
discounted value of the profits it can generate. Because the market for the products and services
sold by a firm and capital markets are not static, the expected flow of profits changes with new
information, and the value of equity is always in flux. In publicly traded companies, ownership
of the corporation is shared among stockholders according to their stockholdings. In the event of
liquidation, stockholders are entitled to a share of the proceeds that remain from selling off the
assets of the company and repaying the firm’s creditors. If portions of the company’s equity are
traded on a regular basis on the stock market, there is a readily observable price for the entirety of
the firm’s equity: the price of a share multiplied by the number of shares outstanding.

84 Ad Hoc comments at 18.
85 Id.
86 Id.
87 47 C.F.R. § 65.301. (“The cost of equity shall be determined in represcription proceedings after giving
full consideration to the evidence in the record, including such evidence as the Commission may officially
notice.”).
88 John R. Graham and Campbell R. Harvey, The Theory and Practice of Corporate Finance: Evidence from
the Field, 60 J. FIN. ECON. at 187-243 (2001) (Graham and Harvey).
89 USF/ICC Transformation Order, 26 FCC Rcd at 18054, para. 1055 (citing 1990 Represcription Order, 5
FCC Rcd at 7527-29, paras. 174-189).
90 NECA et al. Comments at 56-57 and App. C, Statement of Prof. Randall S. Billingsley at 6-7, 15-26.
91 Ad Hoc Comments at 5-7.
92 See, e.g., Phillips, Charles F. Jr., The Regulation of Public Utilities, Public Utilities Reports, Inc., (1993)
at 394-97.
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53.
In privately held firms, including the overwhelming majority of RLECs,
however, equity cannot be readily measured, even though an equity figure is reported in their
balance sheets. Unlike in publicly traded firms, in private firms claims to the residual value of
the assets of the company after repaying its creditors are not traded in a market. Therefore, there
is no market price reflecting the consensus of investors as to the value of a private firm’s equity;
that value can only be inferred by looking at comparable publicly traded companies.
54.
The cost of equity of a firm is the return that investors require given the
perceived risk of the firm’s expected stream of future profits. In the case of publicly traded
companies, one can observe the stock market price of equity, and any dividends it pays, and can
estimate the after-the-fact cost of equity based upon these data. But as explained above, in the
case of privately held companies, the price of equity is not observed. Accordingly, the
established practice in finance to estimate the cost of equity for private firms is to find publicly
traded firms that have similar risk as the private firms. The cost of equity is estimated for these
publicly traded companies, and that estimate is attributed to the private ones.93
55.
The effort to identify publicly traded firms with risks similar to those of privately
held firms has two obvious limitations. First, there may be important, unobserved risk factors
that drive a firm to become publicly traded in the first place. This makes it likely that even if the
company appears to be identical in risk to the private firm whose cost of equity is being
estimated, important though unobserved differences that could affect the cost of equity remain.
Second, it is not likely that a publicly traded firm will be identical to a privately traded one even
in the observable risk characteristics, making the choice of representative firms an ultimately
imperfect and subjective method.
56.
As the cost of equity reflects the uncertain expectations of investors, there is
potential for introducing significant errors into the estimates, and no single model can be counted
on exclusively to provide a precise estimate of the cost of equity. Each methodology has
conceptual shortcomings, requires the use of informed judgment, and involves measurement
error. We discuss these models, and their strengths and weaknesses, below.94

93 The Commission also sought comment on the importance of flotation costs, small costs associated with
the issuance of stocks or bonds, for our cost of equity calculations, USF/ICC Transformation Order, 26
FCC Rcd at 18054, para. 1055, but received little comment. See, e.g., NECA et al. Comments, App. C,
Statement of Randall S. Billingsley at 7. Of all carriers with at least one rate-of-return study area, we have
identified fewer than twenty that are publicly traded. Because flotation costs tend to be proportionately
small, and are primarily relevant for public companies issuing new securities, we believe that they are not
significant for the vast majority of RLECs (which are not publicly traded) and have not been incorporated
into calculations meant to be representative of RLECs in general.
94 NECA has provided an estimate of the cost of equity based upon another model, a Free Cash Flow (FCF)
model analysis in which current free cash flow is divided by the value of the firm. See NECA et al.
Comments at 57-60. Based upon its analysis, NECA concludes that the average value for cost of capital is
between 11.75% and 23.49%. Id. at 59-60. NECA does not provide sufficient information regarding its
analysis to allow meaningful assessment of its calculations. NECA’s analysis is based upon
unsubstantiated assumptions about the value of RLEC lines instead of demonstrated market values (see
NECA et al. Comments at 58 (“RLEC lines may be more valuable than price cap companies’ rural lines for
at least two reasons. First, RLEC lines are in better shape because these companies have heretofore
focused their full attention, investment and maintenance upon their rural exchanges,”); arbitrarily reduces
price-per-line data (see NECA et al. Comments at 59 (“Since 2008, sale prices for RLECs and price cap
exchanges suggest a range between $3200 and $1500 per line. [footnote omitted]. Sales prices in prior
years were considerably higher, and the likelihood of continued decline in P is not unreasonable. Therefore,
it appears reasonable to use a $2500 to $1200 price-per-line range to produce cost of capital estimates,”);
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57.
Limitations of Models Used to Estimate the Cost of Equity. Outside of the
regulatory context, CAPM is the most widely used model for determining the cost of equity.95
DCF, however, is the most widely used in regulation, and was used in the Commission’s 1990
represcription.96 At that time the Commission chose DCF over CAPM for determining the cost of
equity, but stated that “[w]e continue to believe that the CAPM approach has the potential to
provide estimates of the cost of equity capital with the same reliability as the DCF approach.”97
We use both methods in this Staff Report to estimate the cost of equity
58.
Unlike DCF, CAPM does not require analysts’ predictions regarding changes in
dividends, and so eliminates that particular element of speculation from the equation. By the
same token, however, the inputs required to implement the CAPM, in particular, the expected
beta98 and the expected risk premium, are prone to measurement error because these estimates
involve speculation as to investor expectations.99 The true value of each of the inputs required to
implement the CAPM is unknown, and each is difficult to measure precisely. In formulation, the
constant-growth DCF, the variant of the general DCF model used in the past by the Commission
and in this Report, also assumes that a firm’s dividends grow at the same rate in perpetuity, which
is unlikely. However, it can be argued that in fact it allows for fluctuations around a long–run
average growth rate, and error as to expected dividend payments in the more distant future have a
limited impact on the accuracy of the approach, for example, because investors reasonably could
be expected to largely if not completely discount the value of the dividends they might expect to
receive beyond the foreseeable future.100

relies on a non-random sample of cost companies that chose to respond to a NECA data request (NECA et
al. Comments at 59); and relies on unweighted median data without providing mean data. Id. For these
reasons, we find NECA’s FCF analysis unpersuasive with regard to the issues discussed in this Report.
95 See, e.g., William F. Sharpe, Capital Asset Prices: A Theory of Market Equilibrium under Conditions of
Risk, J. FIN. at 425-442 (1964). Methods such as the Gordon Growth Model or Dividend Discount Model
(DDM) popularized by Gordon and Shapiro in 1959. (See Myron J. Gordon & Eli Shapiro, Capital
Equipment Analysis: The Required Rate of Profit, MGMT. SCI. at 102-110 (1956)) were widely used in
practice prior to this time. (“In the 1940s and 1950s, prior to the development of the Capital Asset Pricing
Model… the cost of equity capital was backed out from the cash flows that investors could expect to
receive on their shares in relation to the current price of the shares. A popular method of estimating the cost
of equity this way was the Gordon and Shapiro (1956) model, in which a company’s dividends are assumed
to grow in perpetuity at a constant rate g.” André F. Perold, The Capital Asset Pricing Model, J. ECON.
PERSP. at 3-24 (2004).
96 1990 Represcription Order, 5 FCC Rcd at 7528, para. 178.
97 Id. at 7523, para. 139. The Commission found that the CAPM estimates submitted in that proceeding
used unrealistically high betas and risk premiums. Id.
98 As discussed in greater detail below, beta is a measurement of the volatility of a company’s stock relative
to the volatility of the market.
99 Eugene F. Fama and Kenneth R. French, The Capital Asset Pricing Model: Theory and Evidence, J.
ECON. PERSP. at 44 n.7 (2004) (Fama and French).
100 To understand why, consider that the general DCF model assumes that the stock price is equal to the
present value of all future dividends, and that the discount rate exceeds the dividend growth rate. As the
discount rate is greater than the growth rate, dividends after some period of time, albeit possibly a long
period, become insignificant. Thus, the constant-growth DCF model is valid as long as a firm is able to
grow at constant growth rate for a sufficiently long period, not forever. For example, assuming a discount
rate of 10% per year, a dividend growth rate of five percent per year, and a current dividend of $1.00 per
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59.
While in a constant-growth DCF analysis, companies with high dividend growth
rates (relative to the expected long-run growth rate of the economy as a whole) may be judged to
have high costs of equity, the incumbent LECs in our sample are forecast to have modest growth
rates. Accordingly, the DCF model is suitable for estimating their cost of equity. Furthermore, to
the extent that any of the firms in our sample have growth estimates that might be judged high,
we note that firms have in the past (and can in the future) grow at above average rates for long
periods of time, periods long enough that investors might place little or no weight on the returns
that might be expected to be available at the time that growth starts to slow significantly. To
estimate future dividends, it is standard practice to rely on the consensus estimates of industry
analysts.101 We consider this reasonable, since investors, particularly institutional investors that
routinely buy and sell significant quantities of stocks, rely on these analysts’ estimates when
making such decisions.102 The analysts’ estimates are expensive to produce, and the services that
collect the available range of estimates have substantial prices, indicating that the purchasing
investors significantly value such services. Moreover, even if analysts’ growth estimates turn out
to be too high or too low in hindsight, arguably such error is largely irrelevant. As long as
investors base their expectations on the analysts’ estimates, these are the estimates, regardless of
whether they are too optimistic or too pessimistic, that are reflected in the market price of
equity.103
60.
The DCF model cannot be used to estimate the cost of equity for companies that
do not pay dividends on a regular basis, however, such as Cincinnati Bell. For these companies,
we cannot calculate the cost of equity using the DCF model and thus will lack a second estimate
to corroborate the company-specific results of the CAPM.
61.
As for the CAPM, there is compelling evidence that it does not accurately predict
equity returns, which is the ultimate test for a model used specifically for the purpose of
estimating the cost of equity, as we do here.104 Moreover, a substantial fraction of investors are
not significantly diversified, and face company specific-risk, contrary to a key assumption of the
CAPM.105 Also, beta, the lone risk factor in the CAPM, arguably needs to be supplemented with
other risk variables, such as dividend yield, firm size, and skewness, to explain security returns.106
And there are real-world constraints on investor borrowing, such as on short selling, contrary to

year that is paid annually, the present value of the dividend payment in year 50 is approximately 10 cents,
and in year 115 this value is approximately zero.
101 See, e.g., 1990 Represcription Order, 5 FCC Rcd at 7515, para. 67; Morin New Regulatory Finance at
297-303; Giacchino and Lesser at 253.
102 1990 Represcription Order at 7529, para. 188. The Commission previously found the use of consensus
forecasts of industry analysts to be a reasonable approach to estimating dividend growth rates, and relied on
them in the 1990 Represcription Order.
103 Some argue that earnings growth rate estimates of analysts that work for investment banking and stock
brokerage firms tend to be overstated, and use of these estimates in the DCF model tends to bias cost of
equity estimates upward. See Peter D. Easton and Gregory A. Sommers, Effect of Analysts' Optimism on
Estimates of the Expected Rate of Return Implied by Earnings Forecasts, J. ACCT. RES., 983-1015 (2007);
Morin New Regulatory Finance at 299-302.
104 See, generally, Fama and French; Morin Regulatory Finance at 338; Morin New Regulatory Finance at
175–89.
105 Morin New Regulatory Finance at 175.
106 Morin Regulatory Finance at 338; Morin New Regulatory Finance at 175-89.
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one of the CAPM assumptions.107
a.

Capital Asset Pricing Model (CAPM)

62.
The Capital Asset Pricing Model is widely used by financial practitioners in
industry to calculate the cost of equity of publicly traded firms.108 For example, a survey of 392
Chief Executive Officers in the United States found that “CAPM is by far the most popular
method of estimating the cost of equity capital: 73.5 percent of respondents always or almost
always use the CAPM.” 109 It is the benchmark for academic research in finance.110 Using the
CAPM estimates of the cost of equity for a representative firm to calculate the WACC for
regulated industries is also standard procedure.111 CAPM starts out with the assumption that
investors face a tradeoff between assets with high returns and high volatility and assets with low
returns and low volatility, with volatility understood as the standard deviation of returns.
Investors then create a diversified portfolio of assets that give them the highest rate of return
possible for their chosen level of risk. The model then further assumes that all investors have the
same expectations about the behavior of the market, an assumption that is sufficient to derive the
market equilibrium rate of return for any given asset.
63.
The required rate of return in CAPM is:

Asset rate of return = Risk free interest rate + Asset Beta*Market Premium

The risk free interest rate is the return that investors can get on their money having the certainty
that there will be no default. U.S. government securities are considered to fulfill this role, as
there are few alternative assets, if any, which have a higher probability of full repayment than
U.S. government debt.112
64.
Long-term Treasury yields should be used in the CAPM as the risk-free-rate
because common stock is a long-term investment.113 As a long-term investment, the expected
rate of return on common stock depends on long-term cash flows. Moreover, RLEC assets have

107 Morin New Regulatory Finance at 175, 177.
108 108 The efficient market hypothesis is the foundation upon which the CAPM (and the DCF model) is
based, and there are no real alternatives to estimating the cost of equity that are not based on it. See
Giacchino and Lesser
at 250-251. The hypothesis has sharp critics. Id.; see also Robert J. Shiller, From
Efficient Markets Theory to Behavioral Finance, J. ECON. PERSP. 83-104 (2003).
109 Graham and Harvey at 187–243.
110 See, e.g., Fama and French at 25–46; Giacchino and Lesser at 185.
111 “Regulators use the CAPM to establish a “fair” rate of return on invested capital for public utilities and
other firms subject to price regulation. For example, a commission regulating an electric power company
may have to establish a price that the company is allowed to charge its customers for electricity. The
commission will do so by computing the cost of producing the electricity, including an allowance for the
cost of capital…. In computing the cost of capital, a regulatory commission must compensate the providers
of capital for the risk they bear by investing in the electric utility. Because the investors are able to
diversify their investment portfolios, the only risk the regulators need to compensate them for is market
risk, as measured by beta.” Zvi Bodie and Robert C. Merton, Finance at 352 (Prentice Hall 2000)
112 For example, Forbes reports the thoughts of former Federal Reserve Chairman Alan Greenspan on this
issue: “The United States can pay any debt it has because we can always print money to do that. So there is
zero probability of default.” http://www.forbes.com/sites/johntharvey/2012/09/10/impossible-to-default/
(last visited Apr. 15, 2013).
113 See Morin New Regulatory Finance at 151–152.
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long useful lives that typically are financed with long-term securities.114 Thus, the appropriate
risk free rate is the one reflected in long-term (e.g., 10- or 20-year) U.S. Treasury bonds rather
than shorter-term U.S. Treasury notes or bills (e.g., five-year notes, or 90 or 30 day bills).115
Short-term investors would face reinvestment risk at the end of every 90 day period, for example,
because they do not currently know what the rates will be in 90 days, 180, 270, and so on, while
the value of the underlying asset depends on the present value of its long-term future cash flows,
regardless of investors’ investment horizons. Whether a 10-, 20-, or 30-year Treasury bond rate
should be used is an open question. In our detailed analysis below, we take the interest rate on
the 10-year Treasury note as the risk free rate because the standard deviation of the mean
historical equity premium measured relative to returns on 10-year Treasury securities is readily
available. This rate was 1.92 percent as of March 26, 2013.116 Ad Hoc does not specify how it
computed the risk free rate. NECA uses a 20-year Treasury note rate.117 This choice does not
have a major impact on NECA’s cost of equity calculations, which are higher than ours primarily
because of their choice of market premium.
65.
Because we believe the interest rate that is the best predictor of the future interest
rate on government securities is the current interest rate (which is consistent with the hypothesis
that interest rates follow a random walk), we use the current rate as the risk-free interest rate.
This rate incorporates an accurate reflection of investors’ current expectations about the future
rate. The staff recommends using this estimate of the risk free interest rate, which is forward-
looking, because CAPM requires the use of forward-looking values.
(i)

Primary Variables in CAPM

66.
There are a number of variables needed to determine the cost of equity using
CAPM: 1) the choice of which market index is to be used for this analysis; 2) the time period
over which to measure risk; 3) the market premium, which is the market’s return above the return
that would be offered for a risk-free investment; 4) additional risk premiums; and 5) betas, which
measure the volatility of a company’s stock relative to the market. We discuss our analysis of
these variables below.
67.
Choice of Market Index. To calculate the cost of equity using CAPM, the returns
on an individual company’s equity are compared to the returns on equity generally. In theory,
this comparison should be to a comprehensive market portfolio;118 in practice, it is necessary to
select a market index for this comparison. The choice of which market index is to be used has
been debated.119 The S&P 500 is considered a sufficient market index because it includes enough
securities to be broadly representative of the entire market. It is widely used by regulators,120 was

114 Id.; Giacchino and Lesser at 234–35.
115 See generally Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the
Value of Companies
at 217 (McKinsey & Company, Inc. (2000)) (Copeland).
121 http://www.treasury.gov/resource-center/data-chart-center/interest-
rates/Pages/TextView.aspx?data=yield (Last accessed May 2, 2013).
117 NECA et al. Comments, App. C, Statement of Prof. Randall S. Billingsley at 23.
118 See generally, Fama and French.
119 Giacchino and Lesser at 225 (Noting that this point was made in “[s]tudies by Fama [showing] that
when a portfolio has 50 or more assets, the influence of the covariance terms swamps the influence of the
individual variance terms.”).
120 Id.
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used by NECA in its comments, 121 and we use the S&P 500 in this Report. Ad Hoc’s source
does not specify the market index used in its WACC calculations.122
68.
Choice of Time Period. There is general consensus that a long historical time
period is most appropriate in producing risk premium estimates based on historical data.123 Even
unusual events can be repeated in the long run. For this reason, unusual market events should not
be dropped from the sample simply on the basis that they were outliers, a point reinforced by the
recent financial crisis. We use the time period 1928-2012. NECA does not use a historical
market premium, and Ad Hoc does not specify how its market premium is calculated.124
69.
Market Premium. The market premium is defined in the CAPM as the difference
between the return one can expect to earn holding a market portfolio and the risk-free interest
rate. Here we find calculating the historical market premium to be the best approach available to
us, and for the data available to us, we find the reasonable range for market premium ranges from
1.22-10.54 percent.
70.
A survey of 150 finance textbooks found that 129 textbooks consider the
expected market premium to be the relevant variable for estimating the cost of equity, and 82 took
the view that investors consider the average historical market premium to be the best forecast of
the expected market premium.125 It is common to rely on as long a time series as possible when
calculating the average historical market premium.126
71.
A commonly used source, Ibbotson,127 estimates the expected market premium to
be 6.7 percent based on the historical market premium over the twenty-year U.S. government
bond rate.128 The calculation is the arithmetic average difference between the S&P 500 company
stock total annual returns and the government bond income returns (i.e., excluding capital gains
on the bonds)129 over the period 1926-2010.130 Unfortunately, we did not have access to the

121 NECA et al. Comments at 5, App. C, Statement of Prof. Randall S. Billingsley at 22.
122 See the definition of “Cost of Equity” at
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/variable.htm (Last accessed 05/01/2013)
123 Giacchino and Lesser at 225.
124 See the definition of “Cost of Equity” at
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/variable.htm (Last accessed 05/01/2013)
125 Pablo Fernandez, The Equity Premium in 150 Textbooks, J. FIN. TRANSFORMATION, Capco Inst. at 14-18
(2009) (Fernandez), which reports that of 150 textbooks, “129 claim the REP [required (by investors)
equity premium] = EEP [Expected equity premium]” and that “82 books use the HEP [Historical equity
premium] as the best estimation of the EEP.”
126 Morin New Regulatory Finance at 157; Giacchino and Lesser at 235-236.
127 Ibbotson SBBI 2011 Classic Yearbook; Market Results for Stocks, Bonds, Bills, and Inflation, 1926-
2010 (Ibbotson Associates 2011) (Ibbotson). On common use of Ibbotson, see Morin New Regulatory
Finance
at 157-158.
128 Ibbotson at 124, Table 10-1.
129 The income portion of total bond return (i.e., the coupon rate), not the total return, is used on grounds
that the income return better reflects the risk-free portion of the bond return, as realized capital gains or
losses are largely unanticipated by investors. See generally, Ibbotson; see also Giacchino and Lesser at
234. Ibbotson’s 20-year market premium from 1926 to 2010, based on total returns from holding
government bonds, is 5.7 %, a full percentage point less than the rate determined by focusing on income
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underlying data for the Ibbotson calculation to provide a confidence interval around the reported
estimated means. We recommend that the Commission obtain these or similar data.
72.
The average historical market premium above the 10-year risk free rate for the
longest period readily available to us (1928-2012) was 5.88 percent and came from data supplied
by Prof. Damodaran.131 The calculation is the arithmetic average of the difference between the
annual return on the S&P 500, and return on the 10-year U.S. government bond including capital
returns. The interval defined by two standard deviations132 around the 10-year government bond
historical market premium was 1.22-10.54 percent. Statistically, we are approximately 95 percent
confident that the true mean value of the market premium lies within these ranges.133 However,
there is substantial variation in observed market premiums over this period (for example, for the
10-year market premium, the lowest market premium in any year was -56.65 percent, and the
highest 49.27 percent). Ideally, we would have considered the 10- and 20-year historical
premium on government bonds, over both the total bond return and the bond income return.
73.
Surveys are another source for expected market premiums. There are risks
associated with using surveys.134 We considered three surveys, but the range each survey reports
mixes estimates made under differing assumptions, such as the purpose of the survey, the
specified market portfolio, and the specific risk free rate. Consequently, they cannot be formally
compared with each other or any other estimates, but perhaps provide rough sanity test ranges.
The first survey, from 2009, reported an average from 150 finance textbooks of 6.5 percent from
a range from three to ten percent.135 The second, a survey of over 1500 finance and economics
professors conducted during 2010 found that the average market premium estimated by the 462
U.S. based academics in the sample was 6.0 percent, with a range of two to twelve percent. The
third, the January 2013 results of the quarterly poll of American CFOs regularly conducted by
Duke University, found that the surveyed CFOs expect the market premium of the S&P 500 over
the ten-year government bond to be, on average, 3.83 percent, with the surprising range of -32 to

returns only. Ibbotson at 32, Table 2-1. See also, Roger G. Ibbotson, The Equity Risk Premium, RES.
FOUND. CFA INST. at 19 (2011).
130 The reliability of U.S. stock market data prior to 1926 is questionable. Morin New Regulatory Finance
at 158-159.
131 The standard deviation of the market premium was 2.33%. (Aswath Damodaran, Professor of Finance at
the Stern School of Business at New York University,
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html) (last visited Apr. 15,
2013).
132 Here we refer to the estimated standard deviation of the estimated mean market premium. In other
words, we refer to the sample standard deviation of the observed distribution of market premiums, divided
by the square root of the number of years (minus 1) for which we have data, i.e., the square root of 84 – 1 =
83. Because the distribution of the estimated mean approaches a normal distribution as the sample size
grows, for a sample of this size, we can expect that around 95% of the time the mean market premium will
be within two standard deviations of the estimated mean of 5.88%.
133 The range defined by two standard deviations of the estimated mean above and below the estimated
mean is an approximate 95% confidence interval for the mean. This means that there is a 95% chance that
the true mean is within this range. Setting the confidence coefficient at 95% is common. See, e.g.,
Statistical Methods in Discrimination Litigation at 168 (Marcel Dekker 1986); Confidence Limits,
HANDBOOK OF BIOLOGICAL STATISTICS, available at http://udel.edu/~mcdonald/statconf.html (last visited
Apr. 16, 2013).
134 See, e.g., Morin New Regulatory Finance at 161-62.
135 Fernandez at 14-18.
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98 percent.136 The Ibbotson and Damodaran historical averages lie well within these ranges.
74.
Another approach that makes use of expectations is to estimate the average DCF
return to equity for the components of the S&P 500, and obtain the implied market premium by
subtracting the risk-free rate. NECA applied this analysis and found an implied market premium
of 11.2 percent, substantially higher than any other estimate we are aware of (excluding the
obviously very high estimates of some CFOs).137
75.
The Effect of Size on Market Premium. NECA asserts that “[e]xtensive research
documents that small capitalization firms such as the average RLEC also require an additional
risk premium of about 1.53 percent.” However, recent research indicates that the size effect
“seems to vary over time or even disappears,”138 with smaller firms in the United States not
performing significantly better than large ones from 1980 onward. Therefore, we do not
recommend adding a risk premium based on size to the cost of equity.139
76.
Beta. A company’s beta is the coefficient on market returns resulting from a
simple regression of the security’s returns on market returns, i.e., it is a measurement of the
volatility of a company’s stock compared to the volatility of the market. If a company has a beta
of one, changes in the return on a company’s stock are the same as those in the market generally.
If a company’s beta is zero, changes in its returns do not correlate with changes in the market
generally. A beta greater than zero but less than one means a company’s stock generally moves
in the same direction as the market, but not as much as the market. A beta greater than one means
a company’s stock moves in the same direction as the market, but the changes are of greater
magnitude. The returns on stocks with very low betas will fall less when the market goes down
than returns on those stocks with high betas, allowing investors to be less susceptible to market

136 Graham and Harvey. The range of the survey can be found in “March 2013 United States Topline
Tables.” cfosurvey.org. Duke/CFO. Web. 10 Apr. 2013. http://cfosurvey.org/13q2/Q1-13-US-Topline-
Updated.rtf, at 39 (last visited Apr. 16 2013). Since the poll was started in June of 2000, the quarterly
average has never gone below 2.12% or above 4.78%.
137 NECA presents an analysis by Prof. Billingsley that applies the DCF methodology to calculate the
required return for the S&P 500. See NECA et al. Comments, App. C, Statement of Prof. Randall S.
Billingsley at 7; Prof. Billingsley considers that, in a time of economic crisis, and “in the wake of the recent
financial crisis in the U.S.,” investors are pessimistic and demand higher returns than they historically have.
Id. at 22. The DCF approach to estimating the market premium is not without its critics. See Copeland at
222 (Analysts “have shown limited skill in forecasting price changes in the S&P 500. In addition, the
formula that provides the basis for this approach assumes perpetual growth at a constant rate. This is a
particularly stringent assumption.”).
138 Crain, Michael A., A Literature Review of the Size Effect (October 29, 2011), available at SSRN:
http://ssrn.com/abstract=1710076 (last visited Apr. 16, 2013) or http://dx.doi.org/10.2139/ssrn.1710076
(last visited Apr. 16, 2013).
139 But see Giacchino and Lesser at 239 (“Empirical studies have typically found that small firms typically
have higher returns over the long run than larger firms.”). These authors report on the findings published in
the Morningstar 2009 SBBI Valuation Yearbook as to the implied size premiums, measured by subtracting
the estimated CAPM return above the risk-free rate from the actual return above the risk-free rate, for the
period 1926 to 2008, for 10 different firm sizes, based on market capitalization. These premiums, which
would be added to the cost of equity estimates obtained using the CAPM, ranged from 5.81 percent for the
smallest group of firms (the smallest firm in this group had a market capitalization of $1.6 million), to 1.54
percent for the fifth largest group (the smallest firm in this group had a market capitalization of $1.85
billion), to minus .36 percent for the largest group (the smallest firm in this group had a market
capitalization of $18.628 billion), the only group that had a negative size premium. It is unclear whether
Ad Hoc adds a size effect, but their 5.5 percent market premium suggests that they do not.
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risk. This feature makes them particularly attractive, and investors require lower returns from
them. Conversely, assets with high betas will substantially increase their returns only when the
market goes up. Because returns on these stocks tend to improve noticeably only when the
market as a whole is improving, investors require high returns from assets with high betas. Betas
for the RHCs, the Mid-Size Proxies, and the Publicly-Traded RLEC Proxies are included in
Appendix F.140 These betas are based upon a regression analysis of each company’s returns on
stock compared to the returns on the S&P 500 for the 5-year period ending September 18,
2012.141 These estimates are forward-looking inasmuch as recent historical values predict future
ones.
77.
Some additional methodological choices must be made when obtaining betas.
These include the periodicity of returns used in the regression, and whether to adjust the value of
beta towards one.
78.
Periodicity of Data. Data on stock returns are available on a daily basis, and the
SNL Kagan financial service to which the Commission subscribes uses daily data for its beta
regressions. However, weekly data and monthly data are used most frequently both in the
financial academic literature and in practice.142 Appendix F reports betas using daily, weekly,
and monthly data. We note that Ad Hoc uses weekly data143 and NECA uses betas provided by
Value Line, but does not document the underlying methodology. As shown in Appendix F,
however, the variations are inconsequential: our average beta is 0.89, whereas the average Value
Line beta for the companies in our portfolio is 0.85.
79.
Using higher frequency data, such as daily observations, creates certain
problems, but using lower frequency data creates different problems. On one hand, the stocks of
the smallest companies in our portfolio are not traded very frequently, which can lead to
statistical bias in beta calculations based on higher frequency, such as daily, data. On the other
hand, betas calculated with monthly data use fewer observations, and several of them lose
statistical significance in our sample. The betas in this Report have been calculated using daily,
weekly, and monthly data.
80.
Adjustment Towards One. Betas provided by financial services other than SNL
Kagan, such as Bloomberg and Value Line, frequently give a weight of 2/3 to the beta obtained
from simple regression and then add 1/3 to the result.144 This has the effect of making all betas
closer to one. It is meant to account for the empirically observed tendency of betas to move over
time towards the market beta of one.145 Appendix F reports betas with and without this

140 T-statistics and R-squared values associated with these betas are provided in Appendix G.
141 Practitioners very often obtain betas from financial services providers. The staff did not have full access
to any financial information service other than SNL Kagan that would provide methodological details about
their beta calculations. Betas that are publicly available on the Internet rarely include a discussion of their
methodology.
142 Giacchino and Lesser at 225.
143 See the definition of betas at
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/variable.htm (Last accessed 05/01/2013).
144 Id.
145 Marshall E. Blume, On the Assessment of Risk, J. FIN. at 1-10 (1971).
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adjustment.146
81.
Appendix F shows the betas of the 16 representative firms in our portfolio.147
When betas are calculated using daily data on returns, the average beta is 0.81; when weekly data
are used, 0.84; with monthly data, the average becomes 0.75. Adjusting weekly betas for the
empirically observed tendency to revert towards the market beta of one, the average beta is 0.89.
Compared to the market, these are relatively low values. It must be understood that they do not
mean that the U.S. telecommunications utility sector has a low level of risk for investors. They
do mean, however, that much of the risk borne by utility investors can be easily diversified away
by investing elsewhere in the market. In turn, this implies that the required returns on equity for
telecom should not exceed the overall market return on equity. This conclusion does not change
if we focus our attention on the companies that are primarily under rate-of-return regulation. The
average betas using the methods described above become 0.69 (daily), 0.77 (weekly), 0.61
(monthly), and 0.85 (weekly, adjusted toward one), implying even lower required returns on
equity than the overall telecom utility portfolio. While the precision of beta estimates falls as the
portfolio becomes smaller, there is no indication that the smaller RLECs require higher returns on
equity than the rest of the telecom utility portfolio.
82.
To ensure statistical significance, our preferred betas use weekly data. We
adjusted for the tendency to revert toward the market mean of one over time. These betas are
highly statistically significant,148 and are close to those reported by Value Line as of March 27,
2013. Where our Publicly-Traded RLEC Proxies portfolio has an average beta of 0.85, Value
Line has 0.88; with midsize carriers, the difference is between 0.99 and 0.93; for the RBOCs, it is
0.81 versus 0.70; and the averages for the entire portfolio are 0.89 and 0.85, respectively. These
differences are small and changing the set of betas used does not have a significant effect on our
WACC calculations.
(ii)

CAPM Cost of Equity Results

83.
We calculated the cost of equity using CAPM based upon various betas and the
arithmetic mean of the market premium. The results are shown in Appendix H. With our
preferred weekly data adjusted betas, the average cost of equity for the 16 company portfolio is
7.18 percent; for the RBOCs 6.70 percent; for the midsize carriers 7.75 percent; and for the rate-
of-return carriers, 6.90 percent.
84.
As shown in Appendix I1, the CAPM estimates are low compared to the cost of
debt. This is anomalous; because equity is subordinate to debt with regard to a company’s profits
and assets, equity should command a higher return. The arithmetic means of total returns on
large company stocks (those in the S&P 500 index), small company stocks, and long-term
corporate bonds for the period from 1926 to 2010, respectively were 11.90, 16.70, and 6.20

146 Ad Hoc does not use such an adjustment. See the definition of betas at
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/variable.htm (Last accessed 05/01/2013).
NECA uses Value Line betas. Removing the adjustment would change our average beta from 0.89 to 0.84
and would increase the CAPM cost of equity by .31 percent.
147 Some proxy firms have been part of a merger during the last five years. In those cases, we used data
from the acquiring company. Because FairPoint emerged from bankruptcy in 2011, data are only available
for the 19 months preceding our analysis.
148 Both our daily and weekly data based betas are highly statistically significant. HickoryTech has the
lowest t-statistic, 3.93, and a p-value of 0.000 (i.e., the probability of incorrectly rejecting the null
hypothesis that beta equals zero is 0.000.) On the other hand, our estimates using monthly data are not
statistically significant (even at the 10% level) for FairPoint or Shenandoah.
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percent. The differences between the large company stock return and the long-term bond return
and the small company stock return and the long-term bond return were 5.7 and 10.5 percent,
respectively.149 As shown in Appendix I1, the average cost of debt for the 16 company portfolio
is 6.19 percent (versus a 7.18 percent cost of equity); 5.71 percent (versus 6.70 percent) for the
RBOCs; 7.65 percent (versus 7.75 percent) for the mid-size carriers; and 5.15 percent (versus
6.90 percent) for the various rate-of-return carriers. We note that the CAPM estimates of the cost
of debt for six of the sixteen carriers - New Ulm, Alteva, Alaska, Hawaiian, and Frontier - are
actually higher than the cost of equity. For New Ulm: the cost of debt is 5.41 percent (versus
4.83 percent cost of equity); for Alteva: 5.89 percent (versus 5.0 percent); for Alaska: 7.38
(versus 6.84 percent); for Hawaiian: 7.52 (versus 6.30 percent); and for Frontier, 8.27 (versus
7.56 percent). Cost of debt estimates that are higher than the cost of equity for some companies
are likely largely the result of measurement error. By averaging the estimates for the entire
sample of 16 companies, and emphasizing that average in our analysis, however, the effect of at
least some, though not necessarily all, of any such measurement error might be removed. These
anomalies also could reflect in part a higher embedded cost of debt than the cost of debt that
would be issued today. In particular, the cost of debt could have fallen since the 10-K forms upon
which our embedded debt calculations are based were last filed.
85.
While the difference between the cost of debt and the cost of equity would vary
over time and across carriers, the current authorized rate of return was based on an 8.8 percent
cost of debt estimate and a 13.19 percent cost of equity estimate at the time of the 1990
represcription, representing a 4.39 percent difference between the cost of debt and the cost of
equity. That difference is significantly higher than the .99 percent average difference between the
estimates of the cost of debt and the cost of equity for the 16 incumbent LECs that comprise the
Staff Proposed Proxy based on the CAPM estimates in this Report. While both the current and
the 1990 estimates are subject to error, the 0.99 percent difference in the current estimate seems,
as discussed below, to be low, a result that could arise from an overestimate of the cost of debt, an
underestimate of the cost of equity, or a combination of the two. As discussed below, we address
this issue in determining the reasonable CAPM WACC Range.
(iii)

CAPM WACC Range

86.
In this section we establish a range for the cost of equity based on the CAPM,
and a resulting CAPM range for an estimate of the WACC. Variation in our estimates of the
CAPM WACC comes primarily from the choice of the market premium, including choices made
to deal with situations where the cost of equity is found to be too close to, or lower than, the cost
of debt, and so we focus on these.150 Requiring a minimum return to equity necessary to ensure
all carriers’ cost of equity is not less than their cost of debt, we conclude that the CAPM analysis
suggests the WACC most likely lies between 7.39 and 8.58 percent.
87.
Any equity premium less than 7.57 percent results in a cost of equity that is less
than the cost of debt for some of our firms, which violates a fundamental precept of financial

149 Ibbotson, Roger G., The Equity Risk Premium, RES. FOUND. CFA INST. at 19, Tbl 1 (2011).
150 The assumptions behind the various beta estimates of our set of representative companies do not lead to
substantial changes in the average WACC of our portfolio. For example, if we fixed the market premium
at the average historic market rate of 5.88% and looked at the upper and lower CAPM bounds created by
using different beta estimation methods (that is, our four versions of the betas plus betas provided by
external analyst services; see Appendix I2, the resulting WACC range runs from 6.28% to 6.82%. In
contrast, using our preferred betas (weekly data and adjusted towards one), and allowing the market
premium to vary across the range reported in financial textbooks of 3-10% which is narrower than the
historical range we also consider, gives a WACC range of 5.56% to 8.36%.
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economics, strongly implying error in our estimates.151 As an approximation designed to remove
this anomaly, we performed the cost of equity calculation using 7.57 percent as the lower bound
of the market premium, obtaining cost of equity ranges of 8.69-11.35 percent.152
88.
This adjustment is not without its own problems. On one hand, to the extent our
estimates of the cost of debt are too high, this choice would bias upward our estimates of the
return on equity. On the other hand, since the cost of equity typically would materially exceed
the cost of debt, assuming a cost of equity that equals the cost of debt tends to bias our estimates
downwards. It is not clear which of these two offsetting biases is likely to be larger.
89.
The cost of equity ranges that arise from the 16 examined carriers using the
textbook and professorial market premium ranges, the historical confidence interval, and the same
ranges with the truncated market premium range, are illustrated in the chart below. As discussed,
we prefer the historical confidence interval.
90.
CAPM WACC. The CAPM WACCs that result from the CAPM costs of equity
just outlined are reproduced in the chart below. Again, focusing on the cases where no carrier’s
cost of equity is less than its cost of debt, our recommended CAPM WACC range is 7.39-8.58
percent.

151 In the event that a company must be wound up, debt holders are paid ahead of equity holders, and
hence, by definition, equity holders bear more risk than debt holders. To compensate for that risk, equity
holders require a greater return.
152 Using Ibbotson’s long-term risk premium, 6.7 percent, the 20-year government bond yield on March 26,
2013 of 2.75 percent, and the adjusted betas in the CAPM, results in an overall average cost of equity
estimate of 8.74 percent, and a cost of equity estimate for each carrier in the sample that exceeds its cost of
debt estimate. However, if it were available to us, we would still likely have to truncate the 95 percent
confidence interval around this mean.
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91.
Cost of Equity for Different Proxy Groups. Analysis of the CAPM cost of equity
for different proxy groups, as shown in Appendix H, does not demonstrate substantial variation
across subgroups. The variations across these subgroups are not statistically significant.153
92.
In summary, we prefer the two standard deviation spread around the historical
mean market premium observed in the S&P 500 index, but we place a lower bound on the market
premium range that ensures a cost of equity that is no less than the cost of debt for all 16
companies examined. The result is a CAPM WACC range of 7.39-8.58 percent. We note that
this range is between the WACCs based on CAPM analysis provided by Ad Hoc, 6.24 percent,
and by NECA, 12.1 percent.
b.

Discounted Cash Flow

93.
The general discounted cash flow model154 assumes that the price of a share of
stock is equal to the discounted present value of all its expected future dividend payments
extending to infinity.155 Using projections of the firm’s future dividends,156 the general DCF

153 A two-sided statistical test showed none of these averages were statistically different from the other at
the 0.05% confidence level.
154 The general discounted cash flow model is expressed as follows:
Po = D1/(1+Ke) + D2/(1+Ke)2 + D3/(1+Ke)3 and so on continuously
where:
D1, D2… Dn = expected dividends in each year;
Po = current stock price;
Ke = required return on, or cost of, equity.
155 Thus, the value of common stock is expressed as the value of its stream of dividends to infinity. This is
justified by assuming that the investor has an infinite investment horizon, or by assuming that the expected
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model calculates the implicit return on equity required by investors as reflected in the current
price of the stock. The assumption that the price of a share of stock is equal to the expected
present discounted value of the firm’s future dividends is reasonable, as it is a statement of the
efficient market hypothesis. The general DCF model can be modified to accommodate different
dividend growth patterns.
94.
The most widely used modified version of the general DCF model, the constant-
growth, or standard, DCF model,157 calculates the cost of equity as:

Cost of Equity = (Dividends per Share1 /Price per Share0) + g

where Cost of Equity = cost of common stock equity; Dividends per Share1 = annual dividends
per share in period 1; Price per Share0 = price per share in period 0; g = constant growth rate in
dividends per share in the future; and D1 = (1 + g) times D0, the annual dividends per share in
period 0.158 The Commission used this approach in 1990.159 NECA uses the quarterly version of
the constant growth DCF model.160 That version of the model assumes that dividends are paid
quarterly, while the version we use assumes that dividends are paid once a year at the end of the
year.161
(i)

DCF Variables

95.
Historical dividends and share prices are public information. While dividend per
share (DPS) growth forecasts are not generally available, industry analysts routinely make
earnings per share (EPS) growth forecasts, and dividends tend to grow as earnings grow.162 EPS
growth forecasts are commonly used by investors.163 The Commission used EPS growth in the

resale price at the end of a limited horizon is itself a present value of the expected dividends following the
end of that horizon to the new purchaser. See Morin New Regulatory Finance at 250-253.
156 The general DCF model cannot be used to calculate the cost of equity for a firm that does not pay
dividends.
157 The constant-growth DCF model assumes that the stock’s price and expected earnings per share grow at
the same rate as expected dividends. If the stock’s price is expected to grow significantly faster or slower
than dividends, estimates of the cost of equity obtained using the standard DCF model might be
significantly less reliable. See Morin New Regulatory Finance at 256-258.
158 Data from http://finance.yahoo.com/ on Mar. 27, 2013. The dividend in the DCF model is an annualized
dividend reflecting the most recent dividend payment prior to Mar. 27, 2013. We did not multiply g by .5
to calculate D1, as the Commission did the last time it last prescribed the rate of return for incumbent LECs.
1990 Represcription Order, 5 FCC Rcd at 7511, para. 36. It did so then because all of the carriers in its
sample had increased their dividends per share within the prior six months. Id. In contrast, only TDS,
AT&T, and CenturyLink, among the carriers studied here, have done so in the six months prior to March
27, 2013.
159 1990 Represcription Order, 5 FCC Rcd at 7515, para. 67.
160 NECA et al. Comments, App. C, Statement of Prof. Randall S. Billingsley at 15-16.
161 The Commission rejected use of the quarterly version of the constant growth DCF model in 1990
proceeding. See 1990 Represcription Order, 5 FCC Rcd, 7507, at pp. 7515, paras. 70-72.
162 Earnings create the capacity to pay dividends. See Morin New Regulatory Finance at 250-253.
163 The databases that contain EPS forecasts are expensive, but widely used by institutional investors,
indicating that the information contained in them is of considerable value.
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DCF model in the 1990 Represcription Order.164
96.
We obtained long-term EPS growth forecasts online from Yahoo Finance,165
CNN Money,166 Zack’s Investment Research,167 and Reuters,168 to use as estimates of g.169 The
growth forecasts published by these four entities reflect the consensus of analysts that study the
incumbent LEC industry. Yahoo Finance obtains its data from Thomson Financial network,
which is owned by Thomson Reuters.170 Thompson Reuters owns the Institutional Brokers’
Estimate System (IBES), the system from which the Commission obtained its data to estimate g
in the 1990 Represcription Order.171 That database is perhaps the most respected of its kind in
the industry.172 Zack’s is a well-respected firm that has been in business developing consensus
forecasts for many years.173 Reuters is owned by Thompson Reuters. We do not know the source
of the forecast data published by CNN Money. To ensure the quality of future DCF analyses, the
staff recommends that the Commission purchase access to a financial information service
including analyst forecasts of EPS and/or DPS growth, such as IBES. NECA uses the consensus
of the analysts’ earnings-per-share grow rates reported by Zacks. 174
97.
The consensus forecast for the large incumbent LECs, such as AT&T, reflects a
relatively large number of analysts’ views, while the consensus forecast for the RLECs, such as
Shenandoah, reflects a relatively small number. Accordingly, the forecasts for smaller incumbent
LECs should be expected to have greater uncertainty.
98.
We used the current stock price (at the close of markets on March 27, 2013), not
an average price, in the DCF model. The use of the current stock price is consistent with the
semi-strong form of the efficient market hypothesis, which holds that all publicly available
information is fully reflected in current stock prices. Thus, the current price is a better estimate of
the fundamental value of the stock than any other price, and should be used to estimate the cost of
equity, based on this hypothesis.175 NECA uses the average of the three most recent monthly

164 1990 Represcription Order, 5 FCC Rcd at 7519, para. 99.
165 http://finance.yahoo.com (last visited Nov. 9, 2012).
166 http://money.cnn.com (last visited Mar. 27, 2013).
167 http://www.zacks.com (last visited Mar. 27, 2013).
168 http://www.reuters.com/finance (last visited Mar. 27, 2013).
169 Each source other than Reuters describes its long-term forecast as a five-year forecast. Reuters
describes its forecast as a long-term forecast, without specifying how far into the future this forecast
extends. Zacks’ growth estimates also can be obtained online from MSN Money, available at
http://money.cnn.com; and NASDAQ.com, available at http://www.nasdaq.com.
170 See http://finance.yahoo.com (last visited Mar. 27, 2013).
171 1990 Represcription Order, 5 FCC Rcd at 7511, para. 36
172 See Morin New Regulatory Finance at 301-303; Giacchino and Lesser at 253; 1990 Represcription
Order,
5 FCC Rcd at 7515, para 67.
173 See Morin Regulatory Finance at 155-156; Morin New Regulatory Finance at 301-303; Giacchino and
Lesser
at 253.
174 NECA et al. Comments, App. C, Statement of Prof. Randall S. Billingsley at 15.
175 See Morin New Regulatory Finance at 279-280; Edwin J. Elton and Martin J. Gruber, Modern Portfolio
Theory and Investment Analysis at 361 (Wiley 2006).
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closing prices.176
(ii)

DCF Cost of Equity Results

99.
We calculated the cost of equity using the constant-growth DCF model based
upon the four different data sources. The results are shown in Appendix J, and a concise
summary of these results is set out in the table at the end of this section. The average DCF cost of
equity estimates obtained using growth rates from these four different data sources range from
8.88 percent to 10.77 percent. The consensus forecasts from the four sources likely reflect, to
some extent, surveys of the same analysts. In some cases, however, the forecasts differ
significantly and so do the DCF estimates. These DCF estimates have a substantially higher
lower bound than the lower bound on our CAPM estimates of the cost of equity that use the full
range of textbook market premium (8.88 percent compared with 4.60 percent). When the
textbook and DCF ranges are chosen to ensure all of the carriers in our sample have a cost of
equity that is no lower than their cost of debt, the DCF range lies above the CAPM range. These
four cases are illustrated in the chart that follows. Our preferred DCF cost of equity range (as
explained below) is the last of these, 10.54 to 11.58 percent.
100.
While no single source of publicly-available, non-subscription fee-based analyst
projections allows us to produce estimates for all of the dividend-paying carriers in our sample,
given that the magnitude of the forecasts used is relatively modest, and that we are relying on a
sample of companies and forecasts from a number of different and reputable sources, we believe
the constant-growth DCF model provides reasonable estimates of the DCF-based cost of equity.
101.
DCF does not appear to produce reliable estimates for Windstream and ACS
based upon published consensus growth rates. The published growth rates are low, and use of

176 The Commission used the average of the monthly high and low stock prices in the 1990 proceeding.
See 1990 Represcription Order, 5 FCC Rcd, 7507, at pp. 7514, paras. 61-63.
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these rates in most cases results in cost of equity estimates that are less than the cost of debt
estimates for these two firms, and in one case a negative cost of equity estimate for
Windstream.177 These results make no economic sense, even though it is plausible for analysts to
project low and even negative growth in earnings per share. As equity is more risky than debt, no
rational investor would ever purchase any firm’s common stock if that firm’s debt is expected to
provide a higher rate of return. And no investor would ever pay a positive price for a common
stock on which the expected rate of return is less than zero. These anomalously low cost of
equity estimates reflect a limitation of the constant-growth DCF model: it is unlikely to produce a
reasonable cost of equity estimate when the growth rate is very low or high. Indeed, when
developing the cost of equity in the 1990 Represcription Order, the Commission applied a screen
designed to remove from consideration those firms for which the cost of debt exceeded the cost of
equity.178
102.
However, depending on the source, excluding Windstream and ACS, the average
of the growth forecasts ranged from 3.45 to 5.78 percent.179 No DCF estimate is made for New
Ulm Telecom or Alteva because none of the sources that we used publish a long-run growth rate
forecast for these carriers. No DCF estimate is made for FairPoint, Cincinnati Bell, or Hawaiian
Telcom because these carriers do not pay common stock dividends. Depending on the source
used, the average cost of equity for as many carriers that pay dividends and for which a growth
rate was published online, including Windstream and ACS, ranges between 8.88 percent and
10.77 percent. The average cost of equity estimates range between 9.38 and 10.94 percent for the
RBOCs, 8.28 and 11.72 percent for the rate-of-return carriers, and 5.85 and 14.27 percent for
percent for the mid-size carriers. For the reasons given above, we remove Windstream and ACS
from the sample we use to estimate the cost of equity. Excluding Windstream and ACS, the
average cost of equity for the entire sample of dividend-paying carriers ranges from 10.40 to
11.44 percent, while the average cost of equity for the remaining midsize carrier, Frontier, ranges
from 11.83 to 16.79 percent.180

177 These growth rates for Windstream vary from minus 11.25 percent to positive 0.01 percent, depending
on the source. The growth rate estimates that Zacks (1%) and CNN Money (-2%) provide for Windstream
result in cost of equity estimates of 13.41% and 10.04%, respectively. These equity cost estimates are
greater than the debt cost estimates for Windstream, 7.33%. In contrast, the growth rate estimates that
Yahoo Finance (-11.25%) and Reuters (-6.83%) provide for Windstream result in cost of equity estimates
of negative .35% and 4.62%, respectively. These equity cost estimates are less than the debt cost estimate.
Only two of the four sources provide a growth estimate for ACS. The growth rate estimates that Yahoo
Finance and CNN Money provide are the same (negative 10%), and this estimate results in a cost of equity
estimate of 1.11%. This equity cost estimate is less than the debt cost estimate for ACS, 7.38%.
178 Some parties in the 1990 prescription proceeding argued that companies whose cost of equity estimates
did not exceed their cost of debt should be excluded from the equity analysis. In response, the Commission
removed from consideration companies whose cost of equity estimates were below the yield on single A
corporate bond ratings. See 1990 Represcription Order, 5 FCC Rcd at 7513-14, paras. 55-58.
179 Excluding Windstream and ACS, the average of the growth rate forecasts is from 1.74 to 3.91%.
180 Neither the cost of equity estimates that are greater than the cost of debt for Windstream nor the
estimates that are less than the cost of debt for Windstream and ACS are reflected in these ranges. Use of
the CNN Money growth rates does result in a cost of equity estimate that is greater than the cost of debt
estimate for Windstream. If we do not remove Windstream’s equity estimate from the estimates that are
based on CNN Money growth rates, the average equity estimate based on this source decreases from 11.44
percent, which is the top of the this range, to 11.30 percent. Use of the Zacks growth rates also does result
in a cost of equity estimate that is greater than the cost of debt estimate for Windstream. If we do not
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103.
To minimize the extent to which we rely on a range of equity cost estimates that
is affected by the number of firms for which each source provides estimates, and to maximize the
extent to which the available growth rate information informs these estimates, we develop a
single cost of equity estimate for each of the 11 firms using all of the growth estimates available
for that firm, and then calculate the average of these cost of equity estimates.181 To do this, we
identify the low and the high estimates among the available estimates for each firm, determine the
midpoint between these two estimates, and use this value as the growth rate in the DCF model for
each firm. We use the midpoint of the high and the low growth rates, rather an average of all of
the growth rates, to avoid applying too much weight to estimates of analysts that might be
reflected in the consensus estimate of more than one source.
Constant-Growth DCF Average Cost of Equity Estimates
g
midpoint,
min. debt
cost =
g
avg. debt
Four g
Four g
midpoint,
- equity
sources,
sources,
g midpoint, min. debt g midpoint, cost diff.,
including
excluding
including
cost =
excluding
if equity
Windstream Windstream Windstream
equity
Windstream
cost <
Group
and ACS
and ACS
and ACS
cost
and ACS
debt cost

RoR carriers

8.28-11.72
8.28-11.72
11.06
11.06
11.06
11.06

Mid-size

carriers
5.85-14.27
11.83-16.79
7.32
9.67
14.31
13.47

RBOCs

9.38-10.94
9.38-10.94
10.55
10.55
10.55
10.55

All carriers

8.88-10.77
10.40-11.44
9.90
10.54
11.25
11.58
104.
The cost of equity estimates based on this midpoint growth rate analysis are in
Appendix J. Based on this analysis, the overall cost of equity estimate for the 11 firms is 9.90
percent. These cost of equity estimates for the rate-of return incumbent LECs, mid-size

remove Windstream’s equity estimate from the estimates that are based on Zacks’ growth rates, the average
equity estimate based on this source increases from 10.40 percent to 10.77 percent.
181 The number of firms for which each source provides analysts’ estimates varies: Yahoo Finance and
CNN Money provide estimates for 11 firms, Zacks for eight; and Reuters for six. The cost of equity
estimates we developed using growth estimates from these sources vary because the growth estimates are
sometimes significantly different for the same firms. For example, the low growth rate estimate for
Frontier is 1.5 percent (based on CNN Money growth rates), while the high estimate for this firm is 6
percent (Yahoo Finance). For that reason, the cost of equity estimate for Frontier varies from 11.83 percent
to 16.79 percent. The cost of equity estimates also are likely to vary because the number of firms for which
each source provides estimates varies. The common subset of firms for which each source does provide
estimates comprises the following six firms: Consolidated, Windstream, Frontier, AT&T, Verizon, and
Century Link. The average estimate of the cost of equity for these six firms ranges from 9.24 (Yahoo
Finance) to 12.09 percent (Zacks). The low average cost of equity estimate for these six firms is higher
than the low average estimate for all of the firms for which any source provides growth rates, as reported
above, 8.88 percent (again, Yahoo Finance), and the high estimate based on the six is higher than the high
estimate for all of the firms, 10.77 percent (again, Zacks’).
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incumbent LECs, and the RBOCs are 11.06, 7.32, and 10.55 percent, respectively. Excluding
Windstream and ACS from the sample, for the reasons given above, the overall cost of equity
estimate using midpoint growth rates for the nine remaining firms is 11.25 percent. The cost of
equity estimate for midsize incumbent LECs is 14.31 percent, which is the estimate for Frontier,
the only remaining midsize firm in the sample, and the estimates for the rate-of-return incumbent
LECs and the RBOCs are unaffected by the exclusion of Windstream and ACS.
105.
There are ways to evaluate the sensitivity of excluding Windstream and ACS
from the sample, other than simply removing these carriers from the sample. One way is to set
the cost of equity estimate for each of these two firms equal to its cost of debt estimate, and then
to recalculate the average of the cost of equity estimates for all of the 11 firms. Setting the cost of
equity estimate equal to the cost of debt estimate for the two firms, while also using the midpoint
growth rates to estimate the cost of equity for the other nine firms, produces an overall average
cost of equity estimate of 10.54 percent. All else the same, this approach would understate the
overall cost of equity for Windstream and ACS and thus the overall average estimate for the 11
firms, because equity is riskier than debt, and investors would expect to receive a higher return on
equity as compared to debt, not the same return. However, if the embedded cost of debt were
greater than the current cost of debt, as of the measurement date for our analysis, then this
overstatement would be at least partially offset.
106.
Another way to evaluate the sensitivity of excluding Windstream and ACS is to
set the cost of equity estimate for each of the two firms equal to the debt cost estimate of each
firm plus the average difference between the cost of equity estimates and the cost of debt
estimates for the other nine firms. Calculating the average difference between the cost of equity
estimates and the cost of debt estimates for the other nine firms, adding this increment to the cost
of debt estimate for Windstream and ACS, and using the midpoint growth rates to estimate the
cost of equity for the other nine firms, produces an average cost of equity estimate of 11.58
percent. All else the same, this approach might also tend to understate the overall cost of equity
for Windstream and ACS. These two firms’ debt cost estimates, 7.33 and 7.38 percent,
respectively, are higher than the average of the debt cost estimates for the other nine firms, 5.64
percent, suggesting that the these two firms’ equity would be riskier than average and have a
greater than average cost. If that is so, then the increment that we add to their debt costs to
estimate their cost of equity would be too small. The table below summarizes our constant-
growth DCF model estimates.
107.
We believe that we should give the most weight to the equity cost estimates that
incorporate the midpoint growth rates, and the least weight to the estimates that incorporate only
growth rates from a single source, because the former estimates simultaneously reflect the larger
body of information reflected in the growth rate estimates from all the sources. We also believe
that to the extent that use of these growth rates produces cost of equity estimates that have no
economic meaning, such estimates should be omitted. Or, at the very least, the impact of
including such meaningless equity costs estimates on the overall estimate has to be taken into
account. In this regard, there is no dispute that equity is riskier than debt and has a greater cost.
Accordingly, cost of equity estimates that are significantly less than cost of debt estimates is
strong evidence of clear error that, if unaccounted for, is likely to impair the results of an equity
cost analysis. Here the inclusion of Windstream and Alaska, both of which have debt cost
estimates that are greater than their cost of equity estimates based on midpoint growth rates,
significantly reduce the overall cost of equity estimate based on the midpoint growth rate
estimates.
108.
We therefore find that the lower bound of a reasonable range for the cost of
equity, based on midpoint growth rates, is, at the very least, 10.54 percent. This lower bound
figure incorporates cost of equity estimates for Windstream and ACS set equal to their cost of
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debt, which, all else the same, is a conservative adjustment. We also find that the upper bound of
this range is 11.58 percent. This upper bound figure incorporates cost of equity estimates for
Windstream and ACS set equal to their cost of debt, plus the average of the differences between
the cost of equity and cost of debt estimates for the other nine firms, which, all else the same, is
also a conservative adjustment. However, the results we obtain, as displayed in the chart below,
do not suggest the existence of any strong positive relationship between the cost of debt and the
cost of equity in the estimates for the nine other firms in our sample. We do not find a reasonable
range to be higher than 11.58 percent, given the data for our sample of firms.

Debt and Equity Costs

0.1800
0.1600
0.1400
0.1200

Cost of

0.1000

Equity

0.0800
0.0600
0.0400
0.0200
0.0000
0.0000 0.0200 0.0400 0.0600 0.0800 0.1000

Cost of Debt

109.
As a rough test of the reasonableness of the lower and upper bound of this range
of cost of equity estimates, we calculate the difference between the average cost of debt estimate
for the sample of the 11 firms and the lower bound cost of equity estimate, on the one hand, and
difference between the average cost of debt estimate and the upper bound cost of equity estimate,
on the other. We then compare these two differences to three benchmarks. The difference
between the average cost of debt for the 11 firms, 5.89 percent, and the lower bound cost of
equity estimate, 10.54 percent, is 4.65 percentage points (or 465 basis points). The difference
between the average cost of debt for these firms and the upper bound cost of equity estimate,
11.58 percent, is 5.69 percentage points (or 569 basis points).
110.
We have three readily-available benchmarks for evaluating the reasonableness of
the debt-equity differences reflected in our lower and upper bound cost of equity estimates. The
first benchmark is 4.39 percentage points (439 basis points). This is the difference between the
cost of debt, 8.8 percent, and the cost of equity, 13.19 percent, on which the Commission’s
current 11.25 percent authorized rate of return is based. This rate of return was developed in 1990
based on the debt and equity costs at that time. The difference between the lower bound cost of
equity estimate and the average of the cost of debt estimates exceeds the debt-equity cost
difference reflected in the Commission’s currently authorized rate of return, but by only 26 basis
points. Thus, these two cost differences are roughly equal. The difference between the upper
bound cost of equity estimate and the average of the cost of debt estimates exceeds the debt-
equity cost difference reflected in the Commission’s current authorized rate by 150 basis points.
Thus, there is a more material difference between the debt-equity cost difference reflected in our
upper bound cost of equity estimate and the debt-equity cost difference reflected in the authorized
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rate of return (which was based on analysis of a different set of firms and is now more than two
decades old).
111.
The second benchmark is the average difference between the large company
stock return, i.e., S&P 500 companies, and the long-term corporate bond return, from 1926-2010,
5.7 percent.182 We use this historical difference as a benchmark to judge the debt-equity cost
difference reflected in our estimates because the returns on debt and equity that investors actually
realize over a long period of time must reflect their expectations; otherwise, they would not
invest. To the extent that the S&P 500 represents the broad portfolio of assets available to
investors (as assumed for the CAPM analysis in this Report), the average S&P 500 company
would have a beta of one. The average beta for the sample of firms in this Report, adjusted for
the tendency of beta to move toward one over time, and estimated using weekly data, is .89. So
the average firm in our sample has a somewhat lower beta, or a lesser amount of non-diversifiable
risk, than the average S&P 500 company. Equity investors in the average S&P 500 company
might therefore require a higher return on the stock of such a company, relative to the return they
would require on that company’s debt, than the return investors might require on an investment in
the stock of the average firm in our sample, relative to that firm’s debt. Keeping that in mind, the
debt-equity cost differences reflected in our lower bound and upper bound cost of equity
estimates, 465 and 569 basis points, respectively, are both less than the historical debt-equity
return differences for S&P 500 firms, 570 basis points. This suggests our DCF cost of equity
range is reasonable.
112.
The third benchmark is the difference between small company stock returns and
the long-term corporate bond returns, from 1926-2010, 10.5 percent.183 This benchmark might be
pertinent to our sample of firms because only four of these firms are S&P 500 firms; the other
firms are much smaller than S&P 500 firms. The debt-equity cost differences reflected in our
lower bound and upper bound cost of equity estimates, 465 and 569 basis points, respectively, are
both significantly less than the historical difference between equity and debt returns for small
company stocks, 1005 basis points. This suggests our DCF cost of equity range might be too
low. However, if it is true that, as other analysis suggests,184 returns to small companies are no
longer statistically different from those of larger companies, then this benchmark does not
provide any insights.
113.
In summary, none of these three benchmarks suggest in a compelling way that
our lower and upper bound estimates for the cost of equity are unreasonable.
(iii)

DCF WACC Range

114.
We recommend that a reasonable DCF WACC Range be established by using the
lower and the upper bound for the reasonable range of cost of equity estimates, i.e., from 10.54 to
11.58 percent, along with the cost of debt and capital structure estimates developed above for
each firm in our sample. When the lower and the upper bound DCF cost of equity estimates are
used to determine the WACC, the DCF WACC Range is 8.45 percent to 8.72 percent. By
comparison, NECA’s WACC estimate based upon a DCF analysis of the cost of capital was
10.85 percent.

182 Ibbotson, Roger G., The Equity Risk Premium, Res. Found. CFA Inst. At 19, Tbl 1 (2011).
183 Id.
184 Crain, Michael A., A Literature Review of the Size Effect (Oct. 29, 2011), available at SSRN:
http://ssrn.com/abstract=1710076 (last visited Apr. 16, 2013) or http://dx.doi.org/10.2139/ssrn.1710076
(last visited Apr. 16, 2013).
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c.

Cost of Preferred Stock

115.
The Commission’s rules specify that the WACC calculations incorporate the cost
of preferred stock.185 Preferred stock is stock that entitles its holders to receive a share of the
assets of the corporation before common stockholders do, and offers other benefits, such as
priority when dividends are paid, that vary across firms. Of the carriers in our representative firm
portfolio, CenturyLink, Cincinnati Bell Telephone Company, TDS and Alteva have issued
preferred stock. Our main source for financial data in this represcription, SNL Kagan, reports
that none of these companies has issued preferred stock since at least January 1, 2000.186 The
data called for by our rules to calculate the cost of preferred stock are either not available to us or
not publicly reported, so we are unable to include the cost of preferred stock in the calculation of
the WACC. We expect that including the cost of preferred stock from the WACC, if we were
able to do so, would not significantly alter our results for the following reasons. The
representative firms do not typically raise capital through the issuance of preferred stock, as
indicated by the prolonged period of time in which they have not done so; most of them do not
issue preferred stock at all. Further, preferred stock is only a small share of the capital structure
for the proxy firms that have such stock. In the case of Cincinnati Bell, for example, on a book
value basis, preferred stock is around three percent of the firm’s capital (debt plus preferred stock
plus common stock), and for Alteva it is roughly a half of a percent. The preferred stock of both
CenturyLink and TDS is not traded frequently and as a result we cannot observe its market price,
which keeps us from being able to calculate the precise share, on a market value basis, of the
preferred stock in the capital structure of these companies. However, the reasons listed above
give us confidence that both these carriers and the companies for which we use them as proxies
follow the same pattern – inclusion of preferred stock in the WACC calculation would not
significantly alter the WACC. Accordingly, we recommend that the Commission waive or
eliminate the requirement to include the cost of preferred stock in the WACC calculation.
4.

WACC Results

116.
Appendix K shows the WACCs resulting from using both CAPM and DCF,
together with the component values of each model and the estimates of the cost of debt and
capital structure.
5.

Establishing the Zone of Reasonableness

117.
As discussed above, in determining the authorized rate of return the Commission
establishes a zone of reasonable estimates of the overall WACC. After identifying this “zone of
reasonableness,” the Commission should determine, based on policy considerations, where to
prescribe the unitary rate of return.187 To determine a zone of reasonableness, we compare the
range of WACCs produced when the cost of equity is determined using CAPM with varying
market premiums,188 and the range produced when the cost of equity is determined using DCF
with varying analysts’ forecasts. These two ranges are illustrated in the chart below.

185 47 C.F.R. § 65.303.
186 See, generally, http://www.snl.com/Sectors/Media/Default.aspx (last visited Apr. 16, 2013).
187 1990 Represcription Order, 5 FCC Rcd at 7508, para. 7.
188 We use weekly adjusted betas for CAPM because we find them optimal for methodological reasons.
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118.
Without strong reasons for preferring one of these sources over another, given
the data available to us, we recommend a zone of reasonableness that runs from 7.39 percent, the
lower bound of the WACC CAPM 95 percent confidence interval, to 8.72 percent, the upper
bound of the DCF WACC range. We note that the zone of reasonableness is between the WACC
estimates provided by Ad Hoc, 6.24 percent, and by NECA, 10.85 percent (using DCF to estimate
the cost of capital)/12.1 percent (Using CAPM to estimate the cost of capital).
a.

Selecting the Unitary Rate of Return: Times Interest Earned
Analysis

119.
As one approach to choosing a unitary rate of return within the zone of
reasonableness, as well as to assess the reasonableness of this range, we provide a Times-Interest-
Earned (TIE) ratio analysis. The TIE ratio shows the number of times that a firm’s earnings
cover its interest obligations189 for a given WACC, and hence is indicative of what various rates
of return mean for the ability of a firm to pay its debts. Consequently, TIE ratio analysis provides
a check on our cost of equity estimates. Based upon this analysis, we recommend that the
Commission select a unitary rate of return near the upper end of the zone of reasonableness.
120.
The TIE analysis is not a substitute for the determination of a zone of
reasonableness; it does not attempt to determine the cost of capital. Rather, it is one of the key
measures that bond rating agencies use to assess a firm’s creditworthiness and to assign corporate
credit ratings.190 Firms often are expected to maintain adequate TIE or similar coverage ratios
under their contractual obligations to debt holders, and lenders evaluate creditworthiness in part
based on the TIE ratio. The ratio can be calculated a number of ways; 191 the TIE ratio often used

189 See Morin Regulatory Finance at 240-243.
190 See Morin Regulatory Finance at 241-242; Morin New Regulatory Finance at 445-446; Giacchino and
Lesser
at 63-64, 107-108.
191 For example, some lenders use after-tax operating income in the numerator of this ratio.
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by bond rating agencies is:

TIE = Earnings Before Interest and Taxes/Interest Charges

121.
To assess the effects of prescribing a rate of return based upon a particular
WACC estimate, we calculate a pro forma TIE ratio for each incumbent LEC in our sample and
compare these ratios to a range of TIE ratios. That is, we calculate the number of times that each
incumbent LEC’s earnings would cover its interest payments, assuming that each earns the same
given rate of return, which in turn equals a particular WACC, and then compare these numbers to
criteria often used by analysts to determine whether a firm’s interest coverage is adequate.
122.
We note that, just as our WACC estimates reflect holding-company cost of debt
and capital structure data, so too do these pro forma ratios. Neither the WACC estimates nor the
pro forma ratios would precisely represent regulated interstate special access or common line
services, even if the holding company WACC and pro forma ratios are precise. Given that the
WACC estimates are based on holding company data, it is logically consistent to evaluate these
estimates by analyzing TIE ratios developed from holding company data.
123.
The TIE ratio analysis is particularly helpful in weighing the impact of a unitary
rate of return on carriers that have WACCs that might differ significantly from the average
WACC. In addition, there are a number of firms in our sample that are highly leveraged and have
a high cost of debt, meaning that these firms have relatively large interest expenses. As the TIE
ratio is specifically designed to determine the ability of a firm to cover its interest payments, it is
especially useful for evaluating WACC estimates relating to a sample that has a number of
highly-leveraged firms, such as ours.
b.

Calculating the TIE Ratio

124.
We calculate for each incumbent LEC in our sample a pro forma TIE ratio for a
number of different WACCs. To calculate these ratios, we assume that each such LEC will earn
a rate of return equal to these various WACCs and use our estimates of each incumbent LEC’s
cost of debt and capital structure,192 the current federal and state corporate income tax rate, and
the implied cost of equity for each WACC estimate.193 The current federal income tax rate is 35
percent,194 and we assume that the current state income tax rate is 5 percent.195 We also assume

192 We note that the value of the pro forma ratio depends only on the percentages of debt and equity; it is
not affected by the absolute amounts debt and equity reflected in these percentages.
193 The return to equity holders is what remains of the total return after the incumbent LEC pays the fixed
amount of the interest obligations on the debt. Thus, there is an implied cost of equity for each WACC,
assuming that the prescribed rate of return is set equal to that WACC. Given D, E, Kd, Kie, and T, as
defined above, and a series of WACC estimates, we calculate the implied cost of equity by rearranging the
WACC equation and by substituting values for these variables into that equation. The rearranged equation
is as follows:
Kie = (WACC – (D/(D+E))Kd)/(E/(D+E)).
194 26 U.S.C. § 11(b)(D). This is the current statutory maximum corporate federal income tax rate. The
revenue requirement on which a rate of return carrier’s interstate rates are based includes an allowance for
recovery of federal income taxes based on this statutory maximum rate. The rate base is net of the amount
of any deferred taxes arising from timing differences between the actual payment of taxes to the
government and the recognition of these taxes in the revenue requirement, which in turn result from
differences between tax depreciation and regulatory depreciation expense schedules.
195 If the state corporate income tax rate is less than 5 percent, then the pro forma TIE ratio is higher than it
should be as the amount in the denominator of this ratio assumes that the carrier is able to recover state
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that all income is available to meet coverage requirements, interest expense is the only fixed
charge, and that the book value of a carrier’s assets, net of depreciation, i.e., the equivalent of
regulated firm’s rate base, equals invested capital.196 The equation that we use to calculate the
pro forma TIE ratios is equivalent to the one above (earnings before interest and taxes divided by
fixed interest charges) and is as follows:

TIE = (((D/(D+E))Kd) + ((E/(D+E))(Kie/(1-T))))/((D/(D+E))Kd)

where:
D = debt outstanding;
E = equity outstanding;
Kd = cost of debt;
Kie = implied cost of equity;
T = composite federal and state corporate income tax rate.197
(i)

Pro Forma

TIE Ratios

125.
Appendix L1 shows the incumbent LEC’s pro forma TIE ratios for WACC
estimates ranging from six percent to 11.25 percent. The capital structure used in calculating
these particular sets of ratios reflects the use of market value capital structures (as used in our
WACC estimates). These ratios vary significantly among the incumbent LECs for a given
WACC estimate. For example, given a six percent WACC estimate, ACS’s pro forma TIE ratio
is .95, while AT&T’s ratio is 6.29. ACS has a relatively large share of debt in its capital structure
and a high cost of debt, so its pro forma TIE ratio is relatively low. Conversely, AT&T has a
relatively low share of debt in its capital structure and a relatively low cost of debt, so its pro
forma
TIE ratio is relatively high. The pro forma TIE ratio also varies significantly for all of the
incumbent LECs over the range of WACC estimates. For example, TDS’s pro forma TIE ratio is
3.73, given a six percent WACC estimate, while its pro forma ratio is 7.54, given an 11.25
percent WACC estimate.

income taxes assuming that the tax rate is 5 percent. The opposite is true if the state income tax rate is
higher than 5 percent.
196 If not all of a carrier’s earnings are available to meet coverage requirements, the pro forma ratio would
be lower because the numerator of this ratio would be lower. If interest expense is not the only fixed
charge, this ratio would be lower if these fixed charges require payment before or at the same time as the
required interest payments because the numerator would then be lower. If a regulated carrier’s rate base is
less than the amount of invested capital, the pro forma ratio would be affected. The most obvious reason
why the two amounts might not be equal is that a regulator might make a disallowance to a firm’s rate base
if an asset that is purchased by the firm and financed by investors is not a prudent investment, or if an asset
is not used and useful in providing service. In this case, the pro forma TIE ratio would be lower as the
numerator would be lower than otherwise because earnings are lower as the authorized rate of return is
applied to a rate base that is net of the disallowance. In addition, if investors finance deferred charges,
deferred pension expenses, or construction work in progress, for example, the amount of invested capital
will exceed the rate base if an allowance for each item is not included in the rate base. If such allowances
are excluded from the rate base, the pro forma TIE ratio again would be lower than otherwise (as the
WACCs in this analysis are not adjusted upward to account for these exclusions from the rate base). See
Morin New Regulatory Finance
, at pp. 15-17, 31-32, 495-97.
197 The composite federal and state corporate income tax rate is .3825, given a federal income tax rate of
.35 and a state income tax rate of .05.
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(ii)

Historical TIE Ratios

126.
Appendix M shows the historical TIE ratio measured at the holding company
level for each of the incumbent LECs in the sample, for the period 2010 to 2012, and the average
ratios for that three-year period.198
127.
The average, historical TIE ratio for AT&T, Verizon, and TDS in 2012 is 3.99.
The average of the three-year average TIE ratios for these incumbent LECs is 4.43.199 AT&T and
Verizon have high (but not the highest) debt ratings from Moody’s (A2 and Baa2 depending on
the security, and A2, A3, and Baa1, respectively), Standard & Poor’s (A- for both), and Fitch (A
for both). AT&T’s 2012 TIE ratio is 4.0, while its three-year average ratio is 4.63. Verizon’s
2012 TIE ratio is 4.83, while its three-year average ratio is 5.17. TDS has ratings near the low
end for investment grade debt from Moody’s (Baa2), Standard & Poor’s (BBB-), and Fitch
(BBB). TDS’s 2012 TIE ratio is 3.16, while its three-year average ratio is 3.50.
128.
Appendix N shows the bond ratings for each incumbent LEC in the sample.
AT&T, Verizon, and TDS currently have investment grade debt ratings from all three of the
major debt rating agencies. Each of the other incumbent LECs does not have investment grade
debt ratings for all of its debt from as many rating agencies as rated its debt, or does not have a
bond rating.
(iii)

TIE Ratio Benchmarks

129.
To assess the affect changes in the authorized rate of return will have on carriers,
we compare carriers’ TIE ratios at different WACCs to three TIE ratio benchmarks. 200 We have
chosen the following benchmarks
1) RUS standards for hardship loans, after-tax TIE Ratio = 1
2) Federal Financing Bank loans standards, TIE Ratio = 1.25
3) CoBank loans standards, TIE Ratio = 1.5.201
130.
For purposes of comparison, we also include a comparison of pro forma TIE
ratios to a TIE ratio of 4.5, which is the average of the TIE ratios from 2010 to 2012 of carriers

198 Fairpoint is omitted from the actual, historical averages and medians for carriers that have below
investment grade debt set forth in Appendix I1-I3 because the relationship between TIE ratios and bond
ratings reflected in these summary statistics otherwise would be skewed by this carrier’s entry into and exit
from bankruptcy.
199 ACS, CBT, Consolidated Communications, FairPoint, Frontier, and Hawaiian Telcom do not have
investment grade stock. CenturyLink’s debt is rated investment grade by Moody’s and Fitch, while
Standard & Poor’s rates its debt speculative grade. Some of Windstream’s debt is rated investment grade
by Moody’s, while Standard & Poor’s and Fitch rate all of its debt speculative. We regard CenturyLink
and Windstream as having speculative grade debt for purposes of this analysis. The actual, historical
average TIE ratio for this category of incumbent LECs in 2012, excluding FairPoint, is 1.48. The average
of the three-year average TIE ratios for these incumbent LECs is 1.94.
200 We note that the RUS analysis is conducted using after-tax earnings. A TIE ratio based on after-tax
earnings is equal to a TIE ratio based on pre-tax earnings if zero earnings are available to equityholders in
the form of dividends or retained earnings after the firm pays its debtholders, creditors, suppliers, etc.,
because in this case the firm would pay no corporate income taxes. If there are positive earnings available
to equityholders, then the pre-tax TIE ratio is greater than the after-tax TIE ratio because in this case the
firm would pay corporate income taxes.
201 See generally, 7 C.F.R. § 1714.
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that have investment grade bond ratings rounded up to the nearest tenth of a percent (the
Investment Grade TIE Ratio). A firm that issues investment grade debt, a grade assigned by the
major bond rating agencies, is unlikely to default on its interest obligations and therefore is able
to issue debt at a relatively low rate of interest. Bond ratings significantly affect investors’
perception of risk, and therefore affect the rate of return that both debt and equity investors
require.202
131.
For this comparison, we compare the pro forma TIE ratios for each carrier in the
Staff Proposed Proxy, calculated in accordance with the procedure described above, to actual,
historical ratios calculated for carriers that have investment grade debt. We calculate actual,
historical ratios for each carrier that has investment grade bond ratings by dividing actual,
historical earnings before interest and taxes by actual, historical interest expense.
(iv)

Analysis of Carrier TIE Ratios at Various WACCs

(a)

Carrier TIE Ratios: Pro Forma

, Pre-Tax,
Market Value Capital Structures

132.
A rate of return of eight percent, a figure that lies roughly in the middle of the
WACC zone of reasonableness, results in an average pro forma TIE ratio of 4.46, which is almost
equal to the investment grade TIE ratio of 4.5. All carriers have pro forma TIE ratios that exceed
1.25, and 15 out of 16 have TIE ratios that exceed 1.5.203 By comparison, a rate of return of nine
percent, a figure roughly at the top of our WACC zone of reasonableness, results in an average
pro forma TIE ratio of 5.10, and all carriers have a pro forma TIE ratio exceeding 1.5. A
significantly higher rate of return, for example, 10 percent, would produce an average pro forma
TIE ratio of 5.74. All carriers exceed a 1.9 ratio, and three exceed 10.0.
(b)

Carrier TIE Ratios: Pro Forma

, Pre-Tax,
Book Value Capital Structures

133.
To be cautious, we also calculate pro forma ratios based on book value capital
structures, instead of the market value capital structures reflected in the pro forma ratios
discussed above. Appendix L2 also shows the incumbent LEC’s pro forma TIE ratios for WACC
estimates ranging from six percent to 11.25 percent, calculated as explained above (except using
book value capital structures). As explained above, a number of the firms in our sample have
high shares of debt in their book value capital structures. And the share of debt for these firms
based on book value capital structures is much higher than the share based on market value
capital structures. On the one hand, the use of market value capital structures to calculate the
WACC benefits the incumbent LECs because the WACC is higher than if book value capital
structures were used. On the other hand, if book value capital structures are representative of
how incumbent LECs finance regulated incumbent LEC services, then the incumbent LECs
would have higher interest payments than the payments implicit in the pro forma ratios based on

202 We use a three-year average ratio, not the most recent year’s average, because the ratio will fluctuate
over time without there necessarily being a change in the debt rating at the same time. None of the firms
that currently have the investment grade debt rating had a rating below that at any point during these three
years. We do not use an average calculated over a longer period than three years because bond ratings are
supposed to be forward-looking.
203 The pro forma TIE ratios reported in this paragraph are calculated based on before-tax earnings. These
ratios would be lower if they were based on after-tax earnings if positive earnings are available to
equityholders, as these earnings would be subject to corporate income taxes. Thus, these pro forma ratios
are not directly comparable to the RUS benchmarks. We make the more precise comparison to the RUS
benchmarks below.
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market value capital structures. Therefore, a given level of earnings would cover interest
payments fewer times than indicated by the pro forma ratios based on market value capital
structures. Another reason to use book values to calculate pro forma TIE ratios is that the TIE
ratios that bond ratings agencies and industry analysts examine typically are based on book value
data.
134.
Based on this second pro forma TIE calculation, and given a rate of return of 8
percent, the average pro forma TIE ratio is 3.37. Two carriers, FairPoint and CBT, have a TIE
ratio below one, three carriers have a ratio below 1.25, and six below 1.5.204 A rate of return of 9
percent would produce an average TIE ratio of 3.86. Two carriers still have a TIE ratio less than
one, one carrier has a TIE ratio of 1.23, all other carriers have a TIE ratio exceeding 1.25, and 13
of 16 exceed 1.5.
(c)

Carrier TIE Ratios: Pro Forma

, After-Tax,
Book Value Capital Structures

135.
RUS examines after-tax TIE ratios based on book value data. We calculate the
pro forma TIE ratio a third way, this time on an after-tax basis using book value capital
structures, so that these ratios are comparable to the RUS benchmarks, using the following
equation: 205

TIE = (((D/(D+E))Kd) + ((E/(D+E))Kie))/((D/(D+E))Kd)

Appendix L3 also shows the incumbent LEC’s after-tax, book value pro forma TIE ratios for
WACC estimates ranging from six percent to 11.25 percent.
136.
A rate of return of 8 percent produces an average after-tax, pro forma TIE ratio
of 2.45. At this rate of return, all but two carriers, FairPoint and CBT, have TIE ratios exceeding
one. Five carriers have TIE ratios less than 1.25, and seven have TIE ratios less than 1.5. A rate
of return of 9 percent produces an average after-tax pro forma TIE ratio of 2.76. At this rate of
return two carriers still have TIE ratios less than one, three carriers have TIE ratios less than 1.25,
and six carriers have TIE ratios less than 1.5. A rate of return of 11.40 percent is required to
produce an after-tax pro forma TIE ratio that equals or exceeds one for every carrier. At that rate
of return, three incumbent LECs still would have after-tax pro forma ratios that are less than 1.50,
and two would have ratios that are less than 1.25. At the same time, a rate of return that high
would produce an average after-tax pro forma TIE ratio of 3.50, a ratio that is much higher than
all of the RUS benchmarks.
c.

TIE Ratio Analysis Conclusion

137.
Based on these analyses, we conclude that an authorized rate of return in the top
half of the zone of reasonableness would strike a reasonable balance between providing highly
leveraged firms with adequate interest payment coverage and providing less leveraged firms with
too much coverage.

204 Id.
205 The numerator of this equation excludes an allowance for corporate income taxes. This equation is
otherwise identical to the TIE equation used to above to calculate pro forma TIE ratios based on before-tax
earnings.
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C.

Grants

138.
Substantial telecommunications infrastructure grants in recent years206 raise the
issue of how such grants might affect carriers’ WACC. Regulated companies should not be
receiving any rate of return on grants. When the grants are received directly by the regulated
company, the grants must be credited to the appropriate plant account.207 This will exclude the
grant from earning the rate of return and exclude the plant getting depreciation expenses.
Crediting the grant to plant account protects the rate payers from paying rate of return on the
plant and also paying for depreciation expenses on the plant that gets included in the cost of
service. However, given the current freeze of cost category relationships for some rate-of-return
carriers,208 plant accounts credited may not be representative and related expenses, for example,
may be allocated unreasonably.
139.
When an affiliated company receives a grant, the grant should be transferred to
the regulated company in accordance with Part 32 of the Commission’s rules.209 Specifically, the
Commission’s rules require that for all assets outside of tariff transactions sold by or transferred
to a carrier from its affiliate, the asset shall be recorded at no more than the lower of fair market
value and net book cost.210 In this case, only the net book value of the investment in excess of
that paid for by the grant would be recorded in the plant account. As above, if the grant is large,
this treatment categorization (separations) may not be representative.
140.
In the case of large grants, the accounting rules may need to be strengthened
and/or modified so that the categorization is more representative and that the investment paid for
by grants, whether directly to the regulated company or transferred to the regulated company by
an affiliate, does not receive depreciation or return treatment.

IV.

CONCLUSION

141.
Developments in the telecommunications industry, regulation, and the
marketplace since the Commission last established a rate-of-return have significantly changed
how the Commission should analyze the rate-of-return carriers should earn. In its last
represcription, the Commission could rely primarily on ARMIS reports. Those reports came
from companies with investment-grade bond ratings—companies engaged in substantially the
same wireline operations as the small incumbent LECs also subject to rate-of-return regulation.
Analyst estimates of the expected growth rates of those companies were plentiful and the
companies’ equity was widely traded.
142.
Today, with those ARMIS reports a thing of the past, and with the largest
telephone companies increasingly dissimilar from the smaller rate-of-return companies, the
Commission must expand its analysis to include smaller carriers to ensure its analysis reasonably

206 See, e.g., Broadband Technology Opportunities Program (BTOP) Quarterly Program Status Report,
National Telecommunications and Information Administration, Sept. 2012 (“In 2009 and 2010, NTIA
invested approximately $4 billion in 233 BTOP projects benefitting every state, as well as five territories
and the District of Columbia.”), available at
http://www.ntia.doc.gov/files/ntia/publications/btop_14th_quarterly_report.pdf (last visited Nov. 16, 2012).
207 47 C.F.R. § 32.2000.
208 Jurisdictional Separations and Referral to the Federal-State Joint Board, CC Docket No. 80-286,
Report and Order, 27 FCC Rcd 5593 (2012) (extending the separations freeze until June 30, 2014).
209 47 C.F.R. § 32.01 et seq.
210 47 C.F.R. § 32.27.
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reflects the circumstances of those smaller incumbent LECs. Doing so raises a number of other
issues. Firms not frequently traded provide less-reliable data from which to determine cost.
Firms in financial distress do not provide meaningful data for some of the essential calculations
necessary to determine a reasonable rate of return.
143.
Based upon the analysis in this Report, we believe the Commission can address
these concerns by using a broad range of publicly-traded incumbent LECs, including the RHCs as
well as mid-size carriers and smaller carriers. Using the data from these carriers, the Commission
can determine zones of reasonableness based upon two different means of calculating the cost of
capital: DCF and CAPM. Based upon the analysis described in this Report, we believe that the
range of 7.39 percent to 8.72 percent represents a robust zone of reasonableness from within
which to select the authorized rate of return. Analyzing the effects of a new rate of return with a
TIE analysis, and given current historically low interest rates and the infrequency of
represcription, we conclude that the rate of return should be at the upper half of that zone of
reasonableness, from 8.06 percent to 8.72 percent.
144.
The data and observations set forth in this Report should provide valuable
assistance to the Commission as it moves forward with prescribing an authorized rate of return
that ensures just and reasonable rates for customers and helps ensure the stability and sufficiency
of the universal service fund while allowing incumbent LECs to continue to maintain their credit
and to attract capital.
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APPENDIX A

List of USF/ICC Transformation Further Notice

Commenters and Reply Commenters

Commenter

Abbreviation

Ad Hoc Telecommunications Users Committee
Ad Hoc
Alaska Regulatory Commission
Alaska Commission
Alaska Rural Coalition
ARC
C Spire Wireless
C Spire
CTIA – The Wireless Association
CTIA
Gila River Telecommunications
Gila River
GVNW Consulting
GVNW
Hopi Telecommunications
Hopi
Mescalero Apache Telecom Inc.
MATI
Moss Adams
Moss Adams
National Association of State Utility Consumer Advocates, Maine
NASUCA et al.
Office of the Public Advocate, New Jersey Division of
Rate Counsel and Utility Reform Network
National Cable & Telecommunications Association
NCTA
Nebraska Rural Independent Companies
Nebraska Rural
NECA, NTCA, OPASTCO and WTA
NECA et al.
Parrish, Blessing & Associates
Parrish
RCA – The Competitive Carriers Association
RCA
Time Warner Cable
Time Warner Cable
T-Mobile USA
T-Mobile
United States Telecom Association
U.S. Telecom
Universal Service for America Coalition
USA Coalition
Windstream Communications
Windstream
Washington Independent Telecommunications Association,
Western Associations
Oregon Telecommunications Association, Idaho Telecom
Alliance, Montana Telecommunications Association and
Colorado Telecommunications Association

Reply Commenter

Abbreviation

Alaska Regulatory Commission
Alaska Commission
Cellular South
Cellular South
GTA Telecom
GTA
GVNW Consulting
GVNW
Louisiana Telecommunications Association Small
Louisiana Small
Company Committee
Committee
Montana Telecommunications Association
Montana Association
National Association of State Utility Consumer Advocates, Maine
NASUCA et al.
Office of the Public Advocate and New Jersey Division of
Rate Counsel
NECA, NTCA, OPASTCO and WTA
Rural Associations
New Mexico Exchange Carrier Group and Mescalero Apache
NMECG and MATI
Telecom Inc.
Pennsylvania Public Utility Commission
PA PUC
RCA – The Competitive Carriers Association
RCA
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Rural Iowa Independent Telephone Association
RIITA
Texas Statewide Telephone Cooperative, Inc.
TSTCI
Universal Service for America Coalition
USA Coalition
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Appendix B

Comparison of RHC Embedded Cost of Debt Found in 1990 Represcription with 10-Year

Treasury Note Yield

10.00
9.00
8.00
7.00
6.00
5.00
4.00

P
e
r
c
e
n
t
a
g
e

P
o
i
n
t
s

10-Year T-Note Yield
RHC Cost of Debt at time
3.00
of 1990 Represcription
2.00
1.00
0.00
1
2
/
3
/
1
9
9
0
1
2
/
3
/
1
9
9
2
1
2
/
3
/
1
9
9
4
1
2
/
3
/
1
9
9
6
1
2
/
3
/
1
9
9
8
1
2
/
3
/
2
0
0
0
1
2
/
3
/
2
0
0
2
1
2
/
3
/
2
0
0
4
1
2
/
3
/
2
0
0
6
1
2
/
3
/
2
0
0
8
1
2
/
3
/
2
0
1
0
1
2
/
3
/
2
0
1
2
Annualized daily yields on 10 year Treasury Notes. Source: SNL Kagan
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APPENDIX C

Discussion of Book Values and Market Values in Calculation of Capital Structure

1. This appendix discusses the strengths and weaknesses of using book and market
values to estimate the capital structure of a firm. The book value of a firm is the book value of its
equity plus the book value of its liabilities. The market value of a firm is the amount that would
have to be paid in a competitive market to purchase the company and fulfill all of its financial
obligations, i.e., it is equal to the sum of the market values of the firms’ equity and debt.
Regulators, including the FCC, typically use book values to determine the capital structure of
firms, while academics and financial analysts favor target values or in their defect market values,
while advising against book values.1
2. While the book and market values of debt are often similar, the book and market
values of equity are not. This difference will lead to different capital structure and WACC
estimates depending on which one is used.

A.

Book Value

3. Book equity records the nominal value of the financial investments made in a
company at the time those investments were made. The book value of equity is the sum of the
nominal dollar value at which funds were invested in the company by the owner(s), plus the
nominal value of earnings retained throughout the history of the firm. Book equity can be split
into two components, neither of which will reflect market valuation: the historical market value
of a company’s shares at the time they were issued (share capital plus additional paid-in capital),
and aggregate retained earnings, recorded in nominal values. When new business opportunities
open up for a company and new future profits seem likely, book values of equity will not
immediately reflect this, even though market values automatically will; and when past
investments are demonstrated to have been unwise, book values are not revised downward as
market values are.
4. There are a number of arguments that support the use of book values when
determining a firm’s WACC. Some rate-of-return practitioners argue that the target capital
structure is reflected in the book values, not the market values, of debt and equity.2 If a firm over

1 See, e.g., H. Kent Baker, J. Clay Singleton, and E. Theodore Veit, Survey Research in Corporate Finance:
Bridging the Gap between Theory and Practice at 142 (Oxford University Press 2011) (“Finance theory
specifies that the weights used to calculate WACC should reflect a firm’s target capital structure . . . .
Clearly, the weights used to calculate WACC should not be book-value weights appearing on the firm's
balance sheet, unless, by coincidence, they also happen to be the capital structure weights that maximize
the firm’s stock price. Book-value weights of debt and equity ignore current market conditions . . . . Some
experts advocate using market-value weights based on the number of shares of common stock, the market
price per share, and the market value of a firm’s outstanding debt. [This] is clearly better than using book-
value weights.”)
2 See Morin New Regulatory Finance at 452. See also John R. Graham and Campbell R. Harvey, How Do
CFOs Make Capital Budgeting and Capital Structure Decisions? J. APP. CORP. FIN. at 12-13 (2002). The
authors found from a survey of 392 CFOs that 19% of firms do not have a target debt ratio; 37% have a
flexible target; 34% have a somewhat tight target or range; and 10% have a strict target. Among regulated
firms, 67% were found to have tight or somewhat strict targets. The authors also found that only 16.4% of
firms say that changes in the market value of equity are important or very important to their debt decisions.
In the Virginia Arbitration, the parties debated the merits of using book or market values to estimate a
firm’s target capital structure. See also Petition of WorldCom, Inc. Pursuant to Section 252(e)(5) of the
54

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time issues debt and equity in increments so as to maintain a long-run target capital structure that
is based on book values, then the return needed to cover the costs of debt and equity has to be
based on book value proportions because these are the actual proportions in which these funds are
issued. In fact, regulators conventionally allow a rate of return on the actual equity and debt
issued, which is what book value reflects.3 In that case, it is (obviously) logically consistent to
use book value weights (along with the embedded cost of debt) to determine the WACC because
the rate of return (which is based upon the WACC) is applied to an original cost rate base4
(essentially a book value rate base). Such ratemaking also is easy to understand and is
administratively efficient.5
5. Use of book value weights (along with the embedded cost of debt and a book value
rate base) is consistent with the belief that investors’ right to a fair and reasonable rate of return
on the capital applies to what they have actually invested in the firm.6 Moreover, as the
contractual obligation as to the amount of interest payments on existing debt is fixed, regulators
prevent equity holders from realizing “windfall” gains or losses when the market rate of interest
increases or decreases by allowing the firm to earn a return equal to the embedded cost of debt
times the book value of debt, plus the cost of equity times the book value of equity.7 Further, if
investors expect a regulated firm actually to earn a return on a book value rate base that, on
average, over a long period of time, is equal to its cost of capital, then the market value of the
firm will (approximately) equal its book value.8 Regulation could then be viewed as successful if

Communication Act for Preemption of the Jurisdiction of the Virginia State Corporation Commission
Regarding Interconnection Disputes with Verizon Virginia Inc., and for Expedited Arbitration, CC Docket
Nos. 00-218, 00-251 (Virginia Arbitration), Rebuttal Testimony of Dr. James H. Vanderweide on behalf of
Verizon Virginia, Inc. at 24-37, dated Aug. 27, 2001; and Surrebuttal Testimony of John I. Hirshleifer on
behalf of AT&T and Worldcom, Inc., at 53-59, dated Sept. 21, 2001.
3 The one instance where the Commission used market values of debt and equity to estimate the capital
structure was in the Virginia Arbitration, where the rate base to which the rate of return was applied was a
market value rate base consistent with the Commission’s Total Element Long Run Incremental Cost or
TELRIC rules that governed in that proceeding. Petition of WorldCom, Inc. Pursuant to Section 252(e)(5)
of the Communication Act for Preemption of the Jurisdiction of the Virginia State Corporation
Commission Regarding Interconnection Disputes with Verizon Virginia Inc., and for Expedited
Arbitration, CC Docket Nos. 00-218, 00-251, Memorandum Opinion and Order, 18 FCC Rcd 17722,
17753-58, paras. 65-76 (WCB 2003).
4 For example, assume that a regulated firm has an embedded cost of debt of 5% (that is, the firm is
contractually obligated to pay debt holders a coupon rate of 5%), a cost of equity of 10%, and book value
rate base equal to $100, $50 of which is financed by debt holders and $50 dollars of which is financed by
equity holders. The book value weights of debt and equity are thus both 50% ($50/$100). The WACC is
7.5%, given these assumptions ((.5 x .05) + (.5 x .1)), and the total required return on rate base is $7.50
(.075 x $100). Of that total return, the debt holders receive $2.50, or a 5% rate of return ($2.50/$50), which
is precisely equal the cost of debt. And equity holders receive a return of $5.00, or a 10% rate of return
($5.00/$50), which is precisely equal to the cost of equity.
5 Conversely, such ratemaking does not perform well in terms of rationing customer demand or incenting
managerial efficiency. See, James Bonbright, Albert Danielsen, and David Kamerschen, Principles of
Public Utility Rates at 300 (Public Utility Reports, 2d ed. 2008).
6 U.S. v. FCC, 707 F.2d 610, 612 (D.C. Cir. 1983).
7 Morin New Regulatory Finance at 452.
8 For example, consider a firm that has a zero long-term growth rate and no debt. These assumptions
require that the firm pays a dividend, otherwise the firm must grow, at least if it is being operated
efficiently. Assume that the firm’s rate base equals net book value.
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the book values and the market values of equity are (approximately) equal to each other.9
6. Book values also provide investors with stability and therefore protect the rate-of-
return calculation against the vagaries reflected in the variability of the market’s valuation of the
firm’s debt and equity.10 Such market variation can be substantial.
7. Finally, the use of book values avoids the circularity problem associated with use of
market values. Specifically, unlike book values, market values reflect investors’ expectations as
to the current or anticipated authorized rate of return, while the regulator is trying to determine
what the authorized rate of return should be independent of market expectations about the current
or anticipated authorized rate of return.11
8. Despite this, book values have a fundamental difficulty: accounting processes do not
effectively capture changes in prices, technology, demand and other circumstances, and
consequently, book values become increasingly disconnected from the underlying assets they are
intended to represent. In some cases, this disconnection can be so severe as to render book values
meaningless.

B.

Market Value

9. The basic critique of book values, just foreshadowed, is that they are not
economically meaningful. As a result, it is a standard practice in applied corporate finance to
infer the target capital structure of a firm on the basis of the market value of its equity, debt, and
other sources of capital.12 The basic argument in favor of this is that market values reflect exactly
the underlying net value of the firm and it assets (at least as presently priced by the market).
However, whether this reflects the target capital structure, rather than merely the current capital

A rate-of-return carrier’s expected earnings, E, are equal to the allowable rate of return, r, times rate base,
assumed to equal book value, B. Thus, E = r x B. The easiest way to identify the firm’s dividend stream is
to assume it pays a constant steady-state dividend, D, consistent with the zero growth assumption, that is, D
equals earnings (assuming zero growth), or D = r x B. The present value of such a stream is r x B/ k, where
k is the market-determined cost of capital for the firm. Alternative dividend streams that would satisfy
investors and the zero growth assumption must have the same present value as this dividend stream;
otherwise they would either affect growth assumptions or fail to satisfy investors.
The market value, M, of a firm’s stock is the present value of the future dividends investors expect to
receive, discounted at the risk-adjusted cost of capital, k: M = D/k = (r x B)/k. Thus, M/B = r/k. The
simplest and really only plausible case for which this formula is true is where M = B and r = k.
See A. Lawrence Kolbe, James A. Read, Jr., and George R. Hall, The Cost of Capital, Estimating the Rate
of Return for Public Utilities at 25-33 (The MIT Press 1984).
9 Morin New Regulatory Finance at 452. This argument should be understood in the narrow sense of
evaluating the outcome, i.e., the end result, of the rate-setting process; it should not to be construed as
endorsing as a starting point an approach by which regulators would set rates so as to produce a market
equity-to-book equity ratio of 1. We note that economic theory suggests that in the long-run in a
competitive industry the market value of a firm’s common equity should equal the replacement cost of its
assets, which will not necessarily be the case when the market and book values of equity are equal. See
Morin New Regulatory Finance
at 376-378.
10 See, e.g., Charles F. Phillips, Jr., The Regulation of Public Utilities at 336-38 (Public Utilities Reports,
Inc. 1993); Morin New Regulatory Finance at 452.
11 Morin New Regulatory Finance at 452-53.
12 See generally Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the
Value of Companies, Chapter 10 (McKinsey & Company, Inc. 2000).
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structure of the firm, remains an open question. There is evidence that financial managers very
often ignore the market value of equity when deciding on how much debt firms should issue.13
10. Market values have the additional advantage of being readily and objectively
observable, at least in the case of publicly listed companies.
11. Using market values, however, presents a regulatory difficulty: market forces
determine the value of a firm’s debt and equity based on expectation of that firm’s earning
capacity, which is exactly what the regulator is trying to control in setting a regulated rate of
return. This introduces circularity in the reasoning. To see this problem, consider a rate of return
that inadvertently allows monopoly pricing. Investors, seeing an attractive asset in the form of
the regulated firm, will seek to buy it, driving its price up until the expected return on the
investment exactly compensates the marginal investor for the risk associated with holding that
asset. This means that if the regulator checks whether they set the right rate of return, it will
appear that they in fact have, because the market price of the asset adjusted to bring expected
returns to investors in line with all other investment opportunities. Thus, to know what the right
rate of return is, the regulator must be careful in treating market valuations as given.

13 See John R. Graham and Campbell R. Harvey, How Do CFOs Make Capital Budgeting and Capital
Structure Decisions? J. APP. CORP. FIN. at 12-13 (2002).
57

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Appendix D1

Historical Book Value Shares of Debt

Company

2012 2011
2010
2009 2008 Average
Alaska Communications Systems Group (ACS)
1.07
1.10
1.04
0.95
0.95
1.02
AT&T Inc. (T)
0.42
0.37
0.35
0.39
0.39
0.38
CenturyLink (CTL)
0.50
0.51
0.43
0.43
0.51
0.48
Cincinnati Bell Inc. (CBB)
1.35
1.40
1.36
1.50
1.57
1.44
Consolidated Communications Holdings (CNSL)
0.90
0.95
0.92
0.92
0.92
0.92
FairPoint (FRP)
1.50
1.12
-0.01
0.00
0.99
NA
Frontier Communications Corporation (FTR)
0.67
0.65
0.61
0.93
0.90
0.75
Hawaiian Telcom (HCOM)
0.69
0.63
NA
NA
NA
NA
HickoryTech Corp (HTCO)
0.73
0.73
0.73
0.78
0.81
0.76
Lumos (LMOS)
0.82
0.86
0.40
0.00
NA
NA
New Ulm (NULM)
0.43
0.43
0.45
0.47
0.50
0.46
Shenandoah Telecommunications Company (SHEN)
0.53
0.45
0.49
0.14
0.18
0.36
Telephone and Data Systems (TDS)
0.27
0.25
0.25
0.25
0.27
0.26
Verizon (VZ)
0.36
0.37
0.34
0.40
0.37
0.37
Alteva (ALTV)
0.49
0.00
0.03
0.07
0.11
0.14
Windstream (WIN)
0.88
0.86
0.90
0.96
0.96
0.91
0.73
0.67
0.55
0.55
0.67
0.63

Group

Average

RHCs
0.43
0.41
0.37
0.41
0.42
0.41
Mid-Size
1.03
0.96
0.78
0.87
1.07
1.03
Publicly-Traded RLECs
0.60
0.52
0.47
0.37
0.46
0.48
58

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Appendix D2

Historical Market Value Shares of Debt

Company

2012 2011 2010 2009 2008 Average
Alaska Communications Systems Group
0.86
0.80
0.52
0.60
0.57
0.67
AT&T Inc.
0.26
0.25
0.25
0.28
0.27
0.26
CenturyLink
0.44
0.48
0.34
0.40
0.55
0.44
Cincinnati Bell Inc.
0.71
0.81
0.82
0.74
0.82
0.78
Consolidated Communications Holdings
0.66
0.61
0.61
0.63
0.72
0.64
FairPoint
0.82
0.90
1.00
0.00
0.89
NA
Frontier Communications Corporation
0.66
0.62
0.45
0.66
0.63
0.61
Hawaiian Telcom
0.65
0.51
NA
NA
NA
NA
HickoryTech Corp
0.51
0.44
0.47
0.51
0.64
0.51
Lumos
0.59
0.50
1.00
1.00
NA
NA
New Ulm
0.58
0.53
0.61
0.60
0.56
0.58
Shenandoah Telecommunications Company 0.39
0.39
0.29
0.06
0.05
0.23
Telephone and Data Systems
0.42
0.35
0.28
0.29
0.31
0.33
Verizon
0.28
0.31
0.31
0.37
0.33
0.32
Alteva
0.19
0.00
0.01
0.04
0.08
0.06
Windstream
0.62
0.56
0.51
0.57
0.57
0.57
Average
0.54
0.50
0.50
0.45
0.50
0.46

Group

Average

RHCs
0.33
0.35
0.30
0.35
0.38
0.34
Mid-Size
0.72
0.70
0.66
0.51
0.70
0.66
Publicly-Traded RLECs
0.47
0.40
0.47
0.45
0.39
0.39
59

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Appendix E

Embedded Cost of Debt

Carrier

2011 Non-current
2012 Debt Non-current
2012 Interest

Embedded Cost of

Long-term Debt

Long-term Debt

Expense

Debt

HTCO
$118,828,000
$135,133,000
$5,749,000
4.53%
TDS
$1,529,857,000
$1,721,571,000
$86,745,000
5.34%
NULM
$39,809,000
$42,494,000
$2,227,000
5.41%
SHEN
$158,662,000
$230,200,000
$7,850,000
4.04%
CNSL
$875,719,000
$1,208,248,000
$72,604,000
6.97%
LMOS
$323,897,000
$304,325,000
$11,921,000
3.80%
ALTV
$0
$14,095,000
$415,000
5.89%

RoR Average

$435,253,143
$522,295,143
$26,787,286
5.14%
WIN
$8,936,700,000
$8,114,900,000
$625,100,000
7.33%
ALSK
$538,624,000
$533,772,000
$39,570,000
7.38%
HCOM
$297,400,000
$292,410,000
$22,183,000
7.52%
FTR
$8,224,392,000
$8,405,488,000
$687,985,000
8.27%
FRP
$992,690,000
$948,470,000
$67,610,000
6.97%
CBB
$2,520,600,000
$2,676,000,000
$218,900,000
8.42%

Midsize

$3,585,067,667
$3,495,173,333
$276,891,333
7.65%

Average

CTL
$21,355,259,000
$19,399,644,000
$1,319,000,000
6.47%
VZ
$50,303,000,000
$47,618,000,000
$2,571,000,000
5.25%
T
$61,299,737,000
$66,358,483,000
$3,444,000,000
5.40%

RBOC

$44,319,332,000
$44,458,709,000
$2,444,666,667
5.71%

Average
Average for

$9,844,698,375
$9,875,202,063
$573,928,688
6.19%

All Carriers

60

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Appendix F

Betas

Carrier

Betas

Betas

Betas

Betas (Weekly Data,

Value

(Daily
(Weekly
(Monthly

Adjusted Towards 1)

Line Beta

Data)

Data)

Data)

HTCO
0.49
0.67
0.88
0.78
NA
TDS
1.08
1.12
1.03
1.08
0.95
NULM
-0.14
0.24
-0.28
0.50
NA
SHEN
1.53
1.31
0.85
1.21
0.85
CNSL
0.94
1.03
1.08
1.02
0.85
LMOS
0.73
0.73
0.33
0.82
NA
ALTV
0.18
0.29
0.42
0.52
NA

RoR

0.69
0.77
0.61
0.85
0.88

Average

WIN
0.82
0.91
1.04
0.94
0.95
ALSK
0.85
0.76
0.66
0.84
0.75
HCOM
0.42
0.62
0.79
0.74
NA
FTR
0.84
0.94
0.77
0.96
0.95
FRP
1.83
1.25
1.22
1.16
NA
CBB
1.10
1.46
1.19
1.30
1.05

Midsize

0.98
0.99
0.95
0.99
0.93

Average

CTL
0.73
0.70
0.74
0.80
0.75
VZ
0.70
0.74
0.56
0.83
0.65
T
0.77
0.72
0.68
0.81
0.70

RBOC

0.73
0.72
0.66
0.81
0.70

Average
Average

0.81
0.84
0.75
0.89
0.85
for All
Carriers

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Appendix G

T-statistics and R-squared Values of Monthly, Weekly, and Daily Betas Used in CAPM

betas using monthly data betas using weekly data
betas using daily data

Carrier

t-statistic
r-squared
t-statistic
r-squared
t-statistic r-squared
HCOM
4.23
0.0305
3.03
0.0733
1.77
0.1108
HTCO
4.95
0.2968
7.83
0.1922
11.03
0.0883
TDS
5.45
0.3388
14.07
0.4341
31.75
0.4451
NULM
-1.33
0.0295
1.9
0.0137
-1.99
0.0032
SHEN
3.63
0.1851
11.05
0.3212
32.19
0.4519
CNSL
8.09
0.5305
14.34
0.4434
30.71
0.4286
LMOS
0.32
0.0072
1.92
0.0501
3.49
0.0338
ALTV
3.3
0.158
4.82
0.0827
5.31
0.022
WIN
7.91
0.5192
13.21
0.4035
32.21
0.4521
ALSK
2.55
0.1012
6.63
0.1455
18.52
0.2143
FTR
5.19
0.317
11.58
0.3418
26.01
0.3498
FRP
1.82
0.121
3.51
0.1009
11.36
0.1917
CBB
5.12
0.3114
13.73
0.4223
24.6
0.3251
CTL
6.27
0.4039
10.35
0.2935
26.77
0.3632
VZ
5.71
0.3599
15.4
0.4789
36.12
0.5093
T
8.19
0.5366
17.63
0.5465
43.6
0.6019
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Appendix H

Cost of Equity: Capital Asset Pricing Model

Carrier

Cost of

Cost of

Cost of

Cost of Equity

Cost of Equity

Equity

Equity

Equity

(Weekly, Adjusted
(Value Line Betas)
(Daily
(Weekly
(Monthly

Betas)

Betas)

Betas)

Betas)

HTCO
4.79%
5.85%
7.07%
6.50%
NA
TDS
8.30%
8.53%
7.95%
8.29%
7.51%
NULM
1.12%
3.35%
0.28%
4.83%
NA
SHEN
10.90%
9.61%
6.89%
9.01%
6.92%
CNSL
7.45%
7.96%
8.26%
7.91%
6.92%
LMOS
6.22%
6.19%
3.84%
6.73%
NA
ALTV
2.99%
3.61%
4.40%
5.00%
NA

RoR

5.97%
6.44%
5.53%
6.90%
7.11%

Average

WIN
6.76%
7.29%
8.03%
7.46%
7.51%
ALSK
6.92%
6.37%
5.82%
6.84%
6.33%
HCOM
4.37%
5.54%
6.55%
6.30%
NA
FTR
6.89%
7.44%
6.46%
7.56%
7.51%
FRP
12.67%
9.25%
9.10%
8.77%
NA
CBB
8.42%
10.48%
8.92%
9.59%
8.09%

Midsize

7.67%
7.73%
7.48%
7.75%
7.36%

Average

CTL
6.22%
6.04%
6.26%
6.63%
6.33%
VZ
6.02%
6.28%
5.19%
6.78%
5.74%
T
6.43%
6.14%
5.93%
6.69%
6.04%

RBOC

6.23%
6.15%
5.80%
6.70%
6.04%

Average

Average

6.65%
6.87%
6.31%
7.18%
6.89%
for All
Carriers

63

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Appendix I1

Weighted Average Cost of Capital

Carrier

Debt/

Embedded Cost of

Cost of

CAPM

DCF

(Debt+

Cost of

Equity

Equity

WACC

WACC

Equity)

Debt

(CAPM
(DCF

Using

Using

Weekly,

Zacks EPS

Adjusted

growth

Betas)

estimates)
HTCO
50.67%
4.53%
6.50%
NA
5.50%
NA
TDS
41.85%
5.34%
8.29%
6.52%
7.05%
6.03%
NULM
58.12%
5.41%
4.83%
NA
5.17%
NA
SHEN
38.56%
4.04%
9.01%
NA
7.09%
NA
CNSL
65.57%
6.97%
7.91%
10.88%
7.29%
8.31%
LMOS
58.55%
3.80%
6.73%
7.43%
5.01%
5.30%
ALTV
18.99%
5.89%
5.00%
NA
5.17%
NA

RoR Average

47.47%
5.14%
6.90%
8.28%
6.04%
6.55%
WIN
62.49%
7.33%
7.46%
13.41%
7.38%
9.61%
ALSK
85.74%
7.38%
6.84%
NA
7.30%
NA
HCOM
59.30%
7.52%
6.30%
NA
7.02%
NA
FTR
66.30%
8.27%
7.56%
15.14%
8.03%
10.59%
FRP
81.95%
6.97%
8.77%
NA
7.29%
NA
CBB
70.69%
8.42%
9.59%
NA
8.77%
NA

Midsize Average

71.08%
7.65%
7.75%
14.27%
7.63%
10.10%
CTL
44.22%
6.47%
6.63%
10.06%
6.56%
8.48%
VZ
27.80%
5.25%
6.78%
11.77%
6.36%
9.96%
T
26.07%
5.40%
6.69%
10.98%
6.36%
9.53%

RBOC Average

32.70%
5.71%
6.70%
10.94%
6.42%
9.32%

Average for All

53.55%
6.19%
7.18%
10.77%
6.71%
8.47%

Carriers

64

Federal Communications Commission

DA 13-1111

Appendix I2

Weighted Average Cost of Capital: Alternative Specifications of CAPM Betas

Carrier

Daily Beta Weekly

Monthly

Adjusted Weekly Value Line

WACC

Beta

Beta

Beta WACC

Beta WACC

WACC

WACC

HTCO
4.66%
5.18%
5.78%
5.50%
NA
TDS
7.06%
7.19%
6.85%
7.05%
6.60%
NULM
3.62%
4.55%
3.26%
5.17%
NA
SHEN
8.25%
7.46%
5.79%
7.09%
5.81%
CNSL
7.14%
7.31%
7.41%
7.29%
6.95%
LMOS
4.80%
4.79%
3.81%
5.01%
NA
ALTV
3.54%
4.04%
4.69%
5.17%
NA

RoR Average

5.58%
5.79%
5.37%
6.04%
6.45%
WIN
7.12%
7.32%
7.59%
7.38%
7.40%
ALSK
7.31%
7.24%
7.16%
7.30%
7.23%
HCOM
6.24%
6.72%
7.13%
7.02%
NA
FTR
7.81%
7.99%
7.66%
8.03%
8.02%
FRP
8.00%
7.38%
7.35%
7.29%
NA
CBB
8.42%
9.03%
8.57%
8.77%
8.33%

Midsize

7.48%
7.61%
7.58%
7.63%
7.74%

Average

CTL
6.33%
6.23%
6.35%
6.56%
6.39%
VZ
5.81%
5.99%
5.21%
6.36%
5.61%
T
6.16%
5.95%
5.79%
6.36%
5.87%

RBOC

6.10%
6.06%
5.79%
6.42%
5.96%

Average

Average for

6.39%
6.52%
6.28%
6.71%
6.82%

All Carriers

65

Federal Communications Commission

DA 13-1111

Appendix I3

Weighted Average Cost of Capital: Alternative Sources of Analyst Projections for DCF

Carrier

Yahoo DCF CNN Money

Reuters DCF Zacks DCF Midpoint

WACC

DCF WACC

WACC

WACC

WACC

HTCO
7.07%
11.34%
NA
NA
9.21%
TDS
6.03%
6.03%
NA
6.03%
6.03%
NULM
NA
NA
NA
NA
NA
SHEN
12.29%
11.04%
NA
NA
11.66%
CNSL
8.31%
8.31%
8.31%
8.31%
8.31%
LMOS
5.30%
5.30%
NA
5.30%
5.30%
ALTV
NA
NA
NA
NA
NA

RoR Average

7.80%
8.40%
8.31%
6.55%
8.10%
WIN
4.45%
8.35%
6.31%
9.61%
7.03%
ALSK
6.49%
6.49%
NA
NA
6.49%
HCOM
NA
NA
NA
NA
NA
FTR
11.14%
9.47%
9.78%
10.59%
10.31%
FRP
NA
NA
NA
NA
NA
CBB
NA
NA
NA
NA
NA

Midsize

7.36%
8.10%
8.05%
10.10%
7.94%

Average

CTL
6.61%
6.64%
7.10%
8.48%
7.54%
VZ
9.23%
11.99%
8.79%
9.96%
10.39%
T
9.29%
9.64%
9.53%
9.53%
9.46%

RBOC Average

8.38%
9.42%
8.47%
9.32%
9.13%

Average for

7.84%
8.60%
8.30%
8.47%
8.34%

All Carriers

66

Federal Communications Commission

DA 13-1111

Appendix J

Cost of Equity Using Discounted Cash Flow Model

Carrier

Cost of

Cost of

Cost of

Cost of

Cost of

Equity

Equity

Equity

Equity

Equity

(Yahoo
(CNNMoney (Reuters
(Zacks
(DCF

DCF

DCF

DCF

DCF

Midpoint)

Estimates) Estimates)

Estimates) Estimates)

HTCO
9.68%
18.34%
NA
NA
14.01%
TDS
6.52%
6.52%
NA
6.52%
6.52%
NULM
NA
NA
NA
NA
NA
SHEN
17.47%
15.43%
NA
NA
16.45%
CNSL
10.88%
10.88%
10.88%
10.88%
10.88%
LMOS
7.43%
7.43%
NA
7.43%
7.43%
ALTV
NA
NA
NA
NA
NA

RoR Average

10.40%
11.72%
10.88%
8.28%
11.06%
WIN
-0.35%
10.04%
4.62%
13.41%
6.53%
ALSK
1.11%
1.11%
NA
NA
1.11%
HCOM
NA
NA
NA
NA
NA
FTR
16.79%
11.83%
12.75%
15.14%
14.31%
FRP
NA
NA
NA
NA
NA
CBB
NA
NA
NA
NA
NA

Midsize

5.85%
7.66%
8.68%
14.27%
7.32%

Average

CTL
6.72%
6.77%
7.59%
10.06%
8.39%
VZ
10.76%
14.58%
10.15%
11.77%
12.37%
T
10.67%
11.13%
10.98%
10.98%
10.90%

RBOC

9.38%
10.83%
9.58%
10.94%
10.55%

Average

Average for

8.88%
10.37%
9.49%
10.77%
9.90%

All Carriers

67

Federal Communications Commission

DA 13-1111

Appendix K

CAPM and DCF WACC Ranges

Carrier

CAPM CAPM DCF

DCF

CAPM CAPM DCF

DCF

Cost of Cost of Cost of Cost of WACC WACC WACC

WACC

Equity

Equity

Equity

Equity

Lower

Upper

Lower

Upper

Lower

Upper

Lower

Upper

Bound

Bound

Bound

Bound

Bound

Bound

Bound

Bound

HTCO
7.82%
10.13%
14.01%
14.01%
6.15%
7.29%
9.21%
9.21%
TDS
10.12%
13.34%
6.52%
6.52%
8.12%
9.99%
6.03%
6.03%
NULM
5.67%
7.14%
NA
NA
5.52%
6.13%
NA
NA
SHEN
11.05%
14.63%
16.45%
16.45%
8.34%
10.55%
11.66%
11.66%
CNSL
9.63%
12.66%
10.88%
10.88%
7.88%
8.93%
8.31%
8.31%
LMOS
8.11%
10.54%
7.43%
7.43%
5.58%
6.59%
5.30%
5.30%
ALTV
5.89%
7.45%
NA
NA
5.89%
7.15%
NA
NA

RoR Average

8.33%
10.84%
11.06%
11.06%
6.78%
8.09%
8.10%
8.10%
WIN
9.05%
11.85%
7.33%
13.02%
7.98%
9.03%
7.33%
9.47%
ALSK
8.26%
10.75%
7.38%
13.07%
7.51%
7.86%
7.38%
8.19%
HCOM
7.55%
9.77%
NA
NA
7.54%
8.43%
NA
NA
FTR
9.18%
12.03%
14.31%
14.31%
8.58%
9.54%
10.31%
10.31%
FRP
10.74%
14.20%
NA
NA
7.65%
8.27%
NA
NA
CBB
11.79%
15.67%
NA
NA
9.41%
10.55%
NA
NA

Midsize Average

9.43%
12.38%
9.67%
13.47%
8.11%
8.95%
8.34%
9.32%
CTL
7.98%
10.36%
8.39%
8.39%
7.31%
8.64%
7.54%
7.54%
VZ
8.18%
10.64%
12.37%
12.37%
7.37%
9.14%
10.39%
10.39%
T
8.07%
10.48%
10.90%
10.90%
7.37%
9.15%
9.46%
9.46%

RBOC Average

8.08%
10.49%
10.55%
10.55%
7.35%
8.98%
9.13%
9.13%

Average for All

8.69%
11.35%
10.54%
11.58%
7.39%
8.58%
8.45%
8.72%

Carriers

68

Federal Communications Commission

DA 13-1111

Appendix L1

Pro Forma Pre-Tax Times-Interest-Earned Ratios

(Market Value Capital Structures)

If

If

If

If

If

If

WACC =

WACC =

WACC =

WACC =

WACC =

WACC =

0.06
0.07
0.08
0.09
0.10
0.1125
then TIE then TIE then TIE then TIE then TIE then TIE

Carrier

=
=
=
=
=
=

HickoryTech Corp.

3.62
4.32
5.03
5.73
6.44
7.32

Telephone and Data
Systems, Inc.

3.73
4.46
5.18
5.91
6.63
7.54

New Ulm Telecom Inc.

2.47
2.98
3.50
4.01
4.53
5.17

Shenandoah
Telecommunications

5.62
6.66
7.70
8.74
9.78
11.08

Consolidated
Communications

1.51
1.86
2.22
2.57
2.93
3.37

Lumos Networks Corp.

3.75
4.48
5.21
5.94
6.67
7.58

Alteva

8.07
9.52
10.97
12.41
13.86
15.67

RoR Average

4.11
4.90
5.69
6.47
7.26
8.25

Windstream Corporation

1.50
1.85
2.21
2.56
2.91
3.36

Alaska Communications
Systems

0.95
1.17
1.43
1.68
1.94
2.26

Hawaiian Telcom.

1.56
1.92
2.28
2.65
3.01
3.46

Frontier Communications

1.15
1.45
1.74
2.04
2.33
2.70

FairPoint
Communications, Inc.

1.08
1.37
1.65
1.93
2.22
2.57

Cincinnati Bell

1.01
1.28
1.56
1.83
2.10
2.44

Midsize Average

1.21
1.51
1.81
2.12
2.42
2.80

CenturyLink

2.78
3.34
3.91
4.47
5.04
5.75

Verizon

6.04
7.15
8.26
9.37
10.48
11.86

ATT

6.29
7.44
8.59
9.74
10.89
12.33

RBOC Average

5.03
5.98
6.92
7.86
8.80
9.98

Average for All Carriers

3.20
3.83
4.46
5.10
5.74
6.53
69

Federal Communications Commission

DA 13-1111

Appendix L2

Pro Forma Pre-Tax Times-Interest-Earned Ratios

(Book Value Capital Structures)

If WACC If WACC If WACC If WACC If WACC If WACC

=
=
=
=
=
=
0.06
0.07
0.08
0.09
0.10
0.1125
then TIE
then TIE
then TIE
then TIE
then TIE
then TIE

Carrier

=
=
=
=
=
=

HickoryTech Corp.

2.30
2.79
3.28
3.76
4.25
4.86

Telephone and Data
Systems.

6.13
7.25
8.38
9.50
10.62
12.03

New Ulm Telecom Inc.

3.53
4.22
4.91
5.61
6.30
7.16

Shenandoah Telecom

3.96
4.72
5.49
6.25
7.01
7.97

Consolidated.

0.96
1.19
1.45
1.71
1.97
2.29

Lumos Networks Corp.

2.48
3.00
3.52
4.04
4.55
5.20

Alteva

2.73
3.29
3.85
4.41
4.97
5.66

RoR Average

3.16
3.78
4.41
5.04
5.67
6.45

Windstream
Corporation

0.93
1.14
1.39
1.64
1.89
2.20

Alaska Communications

0.76
0.82
1.02
1.23
1.43
1.69

Hawaiian Telcom

1.90
2.31
2.73
3.15
3.57
4.10

Frontier
Communications

1.13
1.42
1.71
2.01
2.30
2.66

FairPoint
Communications

0.57
0.67
0.76
0.86
0.95
1.12

Cincinnati Bell

0.53
0.61
0.70
0.79
0.88
0.99

Midsize Average

0.97
1.16
1.39
1.61
1.84
2.13

Century Link

2.37
2.87
3.37
3.87
4.37
4.99

Verizon

4.55
5.42
6.28
7.14
8.00
9.08

ATT

3.70
4.42
5.14
5.86
6.57
7.47

RBOC Average

3.54
4.24
4.93
5.62
6.32
7.18

Average for All Carriers

2.41
2.88
3.37
3.86
4.35
4.97
70

Federal Communications Commission

DA 13-1111

Appendix L3

Pro Forma After-Tax Times-Interest-Earned Ratios

(Book Value Capital Structures)

If

If

If

If

If

If

WACC =

WACC =

WACC =

WACC =

WACC =

WACC =

0.06
0.07
0.08
0.09
0.10
0.1125
then TIE then TIE then TIE then TIE then TIE then TIE

Carrier

=
=
=
=
=
=

HickoryTech Corp.

1.80
2.11
2.41
2.71
3.01
3.38

Telephone and Data
Systems, Inc.

4.17
4.86
5.55
6.25
6.94
7.81

New Ulm Telecom Inc.

2.56
2.99
3.42
3.84
4.27
4.81

Shenandoah Telecom

2.83
3.30
3.77
4.24
4.71
5.30

Consolidated
Communications

0.96
1.12
1.28
1.44
1.60
1.80

Lumos Networks Corp.

1.92
2.24
2.56
2.87
3.19
3.59

Alteva

2.07
2.41
2.76
3.10
3.45
3.88

RoR Average

2.33
2.72
3.11
3.49
3.88
4.37

Windstream Corporation

0.93
1.08
1.24
1.39
1.55
1.74

Alaska Communications
Systems

0.76
0.89
1.01
1.14
1.27
1.43

Hawaiian Telcom

1.55
1.81
2.07
2.33
2.59
2.91

Frontier Communications

1.08
1.26
1.44
1.62
1.80
2.03

FairPoint
Communications, Inc.

0.57
0.67
0.76
0.86
0.95
1.07

Cincinnati Bell

0.53
0.61
0.70
0.79
0.88
0.99

Midsize Average

0.90
1.05
1.20
1.36
1.51
1.69

Century Link

1.85
2.16
2.46
2.77
3.08
3.47

Verizon

3.19
3.73
4.26
4.79
5.32
5.99

ATT

2.67
3.11
3.55
4.00
4.44
5.00

RBOC Average

2.57
3.00
3.43
3.85
4.28
4.82

Average for All Carriers

1.84
2.15
2.45
2.76
3.07
3.45
71

Federal Communications Commission

DA 13-1111

Appendix M

Historical Times-Interest-Earned Ratios

Company

2012
2011
2010

Average Rating

AT&T Inc.
4.00
2.86
7.05
4.63
I
Telephone and Data Systems
3.16
4.00
3.36
3.50
I
Verizon
4.83
4.68
5.99
5.17
I
Alaska Communications Systems Group
1.59
1.32
0.97
1.29
S
Cincinnati Bell Inc.
1.16
1.20
1.36
1.24
S
CenturyLink
1.95
1.88
3.81
2.55
S
Consolidated Communications Holdings
1.10
1.84
1.83
3.47
S
Frontier Communications Corporation
1.33
1.37
1.51
1.40
S
Hawaiian Telcom
1.84
1.98
7.80
3.87
S
Windstream
1.43
1.49
1.96
1.63
S
FairPoint
-2.68
6.45
-1.05 0.91
S
HickoryTech Corp
3.37
3.13
5.13
3.88
NA
New Ulm Telecom
2.01
2.20
1.90
2.04
NA
Shenandoah Telecommunications Company
4.64
3.92
7.82
5.46
NA
Alteva
-32.57 -58.47 NA
-45.52
NA
Lumos
3.30
-3.02
7.16
2.48
NA
Averages
Investment Grade Carrier
3.99
3.85
5.46
4.43
Speculative Grade Carrier (excluding FairPoint) 1.48
1.58
2.75
1.94
Source: SNL Kagan, EBIT and Interest Expense figures.
72

Federal Communications Commission

DA 13-1111

Appendix N

Long-Term Bond Ratings

Company

Moody's

S&P

Fitch

Long

Long

Long

Term

Term

ST

Term

AT&T Inc.
A2
A-
F1
A
AT&T Corp
A2
-
-
A
Indiana Bell Telephone Company, Inc.
Baa2
-
-
A
BellSouth Corporation
A2
-
WD
A
Pacific Bell
A2
-
-
A
Southwestern Bell Telephone Company
A2
-
-
A
Verizon
A3
A-
F1
A
Verizon Global Funding Corp
A3
-
-
-
GTE Corporation
Baa1
A-
-
A
Cellco Partnership
A2
A-
-
A
Verizon Wireless Capital LLC
A2
-
-
A
Qwest
Baa3
-
-
BBB-
Qwest Capital Funding
Baa3
-
-
BBB-
Qwest Corporation
Baa3
-
-
BBB-
Mountain States Telephone and Telegraph Co
Baa3
-
-
-
Northwestern Bell Telephone Company
Baa3
-
-
-
Telephone and Data Systems
Baa2
BBB-
-
BBB
United States Cellular Corporation
Baa2
BBB-
-
BBB
Windstream
Ba2
BB-
-
BB+
Windstream Holding of the Midwest
Baa3
BB-
-
BB+
Windstream Georgia Communications
Baa2
BB-
-
BB+
Alaska Communications Systems Group
B1
B+
-
-
Consolidated Communications Holdings
-
B+
-
-
Consolidated Communications Inc.
B1
-
-
-
Consolidated Communications Finance Co
B3
-
-
-
FairPoint
B2
B
-
-
Frontier Communications Corporation
Ba2
BB
-
BB+
New Communications Holdings Inc.
Ba2
-
-
-
Cincinnati Bell Inc.
B1
B
-
B
Cincinnati Bell Telephone Company
Ba1
B
-
B
CenturyLink
Baa3
BB
-
BBB-
Embarq Corporation
Baa3
-
-
BBB-
Centel Capital Corp
Baa2
-
-
-
Carolina Telephone & Telegraph Company
Baa1
-
-
BBB-
Embarq Florida, Inc.
Baa1
-
-
BBB-
United Telephone Co. of Pennsylvania
Baa1
-
-
-
Hawaiian Telcom Inc.
-
B
-
Hawaiian Telcom Communications
B1
-
HickoryTech Corp
-
-
-
-
New Ulm
-
-
-
-
Shenandoah Telecommunications Company
-
-
-
-
Alteva
-
-
-
-
Lumos
-
-
-
-
73

Federal Communications Commission

DA 13-1111

APPENDIX O

Proposed Correction of Rule 47 C.F.R. § 65.302 (Cost of Debt)

The Federal Communications Commission amends 47
CFR part 65 to read as follows:

PART 65—INTERSTATE RATE OR RETURN PRESCRIPTION PROCEDURES AND
METHODOLOGIES

§65.302 Cost of Debt
The formula for determining the cost of debt is equal to:
Where:
“Total Annual Interest Expense” is the total interest expense for the most recent year for all local
exchange carriers with annual revenues equal to or above the indexed revenue threshold as
defined in §32.9000.
“Average Outstanding Debt” is the average of the total debt outstanding at the beginning and at
the end of the most recent year for all local exchange carriers with annual revenues equal to or
above the indexed revenue threshold as defined in §32.9000.
[60 FR 28545, June 1, 1995, as amended at 67 FR 5702, Feb. 6, 2002]
74

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